Friday, December 14, 2018

When Does Permanent Life Insurance Make Sense?

The vast majority of people who need life insurance are best off with term life insurance. Salespeople have tried to sell me permanent life insurance (universal life and whole life), but I never got a good feel for when this type of insurance might make sense. Recently, the Rational Reminder podcast interviewed Glenn Cooke, an expert in insurance who communicates very clearly. Glenn’s explanations allowed me to understand when permanent life insurance may make sense.

Before launching into my take on Glenn’s explanations, let me be clear that Glenn may not fully agree with me. In particular, he might find that the conditions I set out below are too narrow.

Permanent life insurance only makes sense to me when all of the following conditions are met:

  1. You have maxed out both your RRSP room and your TFSA room.
  2. You definitely have more money than you’ll ever need, and you want to leave a legacy (which might include cash to pay off capital gains taxes on a property, such as a cottage, that you want to stay in the family).
  3. You are satisfied that the tax advantages of permanent life insurance outweigh its high fees so that the insurance will likely outperform investments you make in a taxable account.

Explanations of these conditions

1. As Glenn explains, “your RRSPs and TFSAs need to be fully maxed out” because “the management fees inside a universal policy are almost always far higher that they would get outside of a universal life policy.”

2. The cheapest way to protect your family during your working years from the loss of your income is with term life insurance. Getting permanent insurance means you want an insurance payout no matter how long you live. Permanent life insurance “is not liquid and it’s not very flexible. Once you’re in, you’re in, which is why you don’t want any money going into an insurance policy that you might ever need.”

3. If you’re in the position of wanting to grow your legacy as large as possible, all that matters is whether some form of permanent life insurance is likely to outperform other investment options. I’d have to study the details of a universal policy to form an opinion on whether its tax advantages outweigh its high fees.


Some people might argue that condition 2 on its own would be enough to justify buying a universal life policy. Glenn says he has such a policy because he wants to “guarantee there’s an estate there for my kids.” However, if you’re actually running out of money, you’re likely to “cash in” a permanent life insurance policy, so I don’t see any guarantee that the kids will get much money. In fact, if using RRSPs and TFSAs produces better returns than permanent life insurance, then you’re less likely to spend your assets down to zero.

I’m satisfied that permanent life insurance never made any sense for my family. If I were helping a family member or friend with life insurance, I would use the three conditions above. But I’m open to changing my mind if I learn more about life insurance.

Wednesday, December 12, 2018

Bad Arguments Against CPP Expansion

The Canada Pension Plan (CPP) is set to start expanding in January 2019. Workers will begin contributing more of their pay to CPP, and those who contribute more will ultimately receive increased CPP benefits. There are sensible arguments for and against this change, but the most common argument I hear against it makes no sense at all.

I saw a version of this bad argument in an article by Charles Lammam at the Fraser Institute calling on Doug Ford to opt Ontario out of CPP expansion. Lammam calls CPP expansion “unnecessary” because “most Canadians adequately prepare for retirement.” He then goes on to quote statistics on the total dollar amounts Canadians have saved in different asset classes.

All this proves is that, on average, Canadians have enough savings for retirement. But averages are irrelevant in this discussion. Consider two sisters heading into retirement. One sister has twice as much money as she needs and the other has nothing. On average, they’re fine, but individually, one sister has a big problem. CPP expansion is aimed at those who can’t or won’t save on their own.

It’s tempting to ask why we should worry about those who refuse to help themselves by saving for retirement. There are numerous government programs that send tax money to low-income seniors. Three are the Guaranteed Income Supplement (GIS), the Age Amount Deduction, and the Senior Homeowners’ Property Tax Grant in Ontario. As a society, we’ve sensibly decided we don’t want to see seniors begging for food in our streets. An expanded CPP forces more Canadians to save for themselves rather than rely on free tax dollars in retirement.

So, why do we force all Canadians to contribute to CPP when it’s only a minority who won’t save on their own? If CPP were optional, too many of those who need it most would opt out. The only way CPP can serve its purpose well is if it’s mandatory for everyone.

Lammam complains that “Forcing Canadians to contribute more to the government-run pension will simply reduce the amount they save in private voluntary savings vehicles, resulting in little to no overall increase in total savings.” Good. We’re not expanding CPP to get everyone to save more. We just want everyone to save the bare minimum. It’s perfectly sensible for those who are saving well to reduce other savings somewhat and rely more on an expanded CPP.

It’s possible to have a sensible discussion about the merits of expanding CPP. But we should see arguments based on total savings of Canadians or average savings for what they are: a distraction from more meaningful discussion.

Monday, December 10, 2018

How Beneficial is the Dividend Tax Credit?

Many investors love Canadian dividends because they come with a tax break called the Dividend Tax Credit (DTC). Others look a little deeper and say that the DTC just prevents double taxation because the companies paying dividends already had to pay tax on their profits. They conclude that dividend income is no better than interest income, at least from a tax perspective. However, comparing the DTC to capital gains taxes gets more complex.

Dividend Taxation in Canada

The DTC is intended to prevent Canadian company profits paid to Canadian shareholders from getting taxed twice. Here’s an example to illustrate the idea:

Suppose a company earns one dollar in profit per share, pays 27 cents in income taxes, and pays the remaining 73 cents in dividends to each shareholder. Canadian shareholders actually declare the full dollar as income (called the dividend gross-up), but they get to deduct the 27 cents from the taxes they owe. The idea is that the total tax paid by the company and the shareholder is the same as if the shareholder had received a dollar of regular income.

In truth, the numbers don’t work out quite this perfectly. But the DTC does give Canadian shareholders a tax break that mostly covers the corporate income taxes.

Most investors don’t think about the corporate taxes paid and just focus on the tax they pay on the dividends they received. Ontarians in the 53.53% tax bracket pay 39.34% on their eligible dividends. Those in the 20.05% tax bracket actually pay a negative tax rate on their eligible dividends (-6.86%).

Comparing Dividends to Interest

Critics of dividend cheerleaders point out that dividends aren’t taxed any less than interest income once you properly account for corporate taxes. These critics are right. Thanks to reader Garth who pointed me to more detailed explanation of dividend and corporate taxes than I gave above.

This doesn’t mean that dividend-paying stocks are no better than fixed-income products. Taxes aren’t the only consideration. A company’s shares may appreciate even if it doesn’t retain any of its earnings. So, future dividends may be larger than interest payments on a fixed-income product even if neither type of income has a tax advantage. Of course, a company’s share price and dividends can go down as well.

Comparing Dividends to Capital Gains

Dividend cheerleaders look foolish when we compare dividend taxes to interest taxes, but what happens when we compare dividends to capital gains? To me, this is the more relevant comparison. Those who prefer dividend stocks to fixed income products can point to dividend growth as an advantage even if there is no taxation advantage. But when we compare stocks with different levels of dividends and capital gains, the tax difference is important in taxable accounts.

Suppose we are choosing between two baskets of stocks, both expected to earn a compound average return of 5% per year. We expect the dividend stock basket to pay 4% dividends and earn 1% capital gains. We expect the other basket to pay 2.5% dividends and earn 2.5% capital gains. So, the only difference is that with the dividend stocks we trade some capital gains for more dividends.

For both baskets of stocks, the companies have to pay corporate taxes, so we can just leave them out of the comparison. Now dividend cheerleaders don’t look so foolish for ignoring corporate taxes. For any money we withdraw to live on each year, we can just compare dividend tax rates to capital gains tax rates. In Ontario, dividend tax rates look better when our total income is under about $95,000.

But this ignores capital gains deferral. Suppose we spend less than 4% of our savings each year. With dividend stocks, we’d have to reinvest some dividends that we’ve already paid taxes on. With the other basket of stocks, we’d get the advantage of deferring some capital gains taxes to the future when we sell the stocks. Depending on how long we defer the taxes, this can give the capital gains the advantage over dividends down to total incomes as low as $48,000 in Ontario. Note that with the dividend gross-up, our actual received income can be even lower than this.

If we’re expecting our total income (including CPP and OAS) to be lower than $48,000 in retirement, it may seem like we should opt for dividend stocks. But keep in mind that all of this analysis assumes we have a taxable account. It only makes sense to have a taxable account if your RRSP and TFSA are completely full. This tends to be true only if we have large RRSPs that lead to high income in retirement. So, in most cases, capital gains taxes are lower than dividend taxes.

Conclusion

Those who like Canada’s lower tax rate on dividend income appear misguided when we compare dividends to interest income and properly account for corporate taxes. But when we compare dividend taxes to capital gains taxes, it makes sense to ignore corporate taxes and focus on the favourable tax rates for both dividends and capital gains.

Friday, December 7, 2018

Short Takes: Dividend ETFs, Dynamic Pricing, and more

I managed only one post in the last two weeks:

Smart Couples Finish Rich

Here are some short takes and some weekend reading:

Dan Bortolotti has a very sensible take on dividend ETFs.

Squawkfox tells us how to beat dynamic pricing where retailers change online prices based on what they know about you.

Ron Lieber attends a steak dinner annuity pitch and makes the salesman unhappy. A lot of complex financial products look good if you compare them to stocks without their dividends.

The Blunt Bean Counter explains the tax implications of renting out your property Airbnb-style. His explanation is more than enough to scare me away from becoming a casual landlord.

Jason Heath explains the details of how to defer RRIF income taxes when a spouse passes away. There are a number of different cases to consider.

Robb Engen lays out his financial goals for 2019. As usual, my favourite goal is “Don’t take on any new debt.” Without this goal, he could meet all the other goals painlessly by borrowing a pile of money.

Big Cajun Man didn’t hold back on his opinion of GM for closing their plant in Oshawa.

John Robertson reviews Passiv, a tool to automate the management of a do-it-yourself portfolio based on ETFs. It performs some of the functions I’ve built into my investment spreadsheet. It also does some things my spreadsheet can’t do such as sending trades to a brokerage account.

Monday, November 26, 2018

Smart Couples Finish Rich

We can all think of times when we wasted money on things that didn’t matter that much to us and were left without enough money to do things that truly bring us joy. The question then is how do we fix this problem? David Bach offers a step-by-step guide in his book Smart Couples Finish Rich. This book is getting dated, but it offers surprisingly concrete steps to the hard to pin down task of aligning your spending with your values and dreams.

This book is mainly aimed at people still in their working careers, so it’s tough for me to test out its ideas. However, I could imagine myself a decade or two ago being able to follow Bach’s nine steps. How much it would have helped me is hard to guess, but at least the steps are clear enough to go through the exercise.

Parts of this book won’t be too useful to Canadians with the talk of 401(k)s, IRAs, and health insurance. It wouldn’t be too hard for Canadian readers to skip these parts. Some of the examples are becoming quite dated with examples of much higher interest rates than we have now.

More troubling though is some bad advice. When it comes to choosing investments within a company plan, Bach suggests examining “a current list of investment options and a summary of how each of the investments has been performing recently.” Jumping to recent winners is a bad way to invest.

Here is some worse advice: “If you work for a terrific company and you know it’s well run, don’t be afraid to act on that knowledge. I currently have more than 50 percent of my 401(k) money invested in my company’s stock.” I wonder how many WorldCom employees thought their company was well run.

Less serious, but still somewhat troubling is the advice to put emergency funds in money market accounts because they are “incredibly safe.” There is some risk with money market accounts. The kinds of conditions that would put these accounts at risk are exactly the conditions where you’d be very glad to have cash at the ready. Higher returns always come with more risk.

One section does a good job of explaining the benefits of investing in low-cost index funds. But then Bach says index funds are just for the “getting started” phase before you have $50,000. He says to move to a portfolio of mutual funds. Why not stick with low cost investments instead of paying high costs?

Bach claims that with fee-based advice where you pay a percentage of your portfolio for financial advice has “no possible conflict of interest.” This just isn’t true. Commission-based advice may be worse, but fee-based advisors are incented to gather as many assets as possible and do as little as possible to retain clients’ money. Some advisors may do a great job despite this conflict of interest, but the conflict is there nonetheless.

One part I found curious was the claim that we won’t pay less in taxes when we’re retired. In my case, my income taxes dropped more than 90% when I retired. Perhaps this is a difference between being self-employed and being an employee. I paid very high taxes as an employee. Perhaps differences between Canadian and U.S. tax law are a factor as well.

People are too trusting of insurance company promises. Bach is very blunt: “Insurance companies will do just about anything they can to avoid having to pay out benefits—including hiring an investigator to check you out.” He’s not against getting sensible insurance; he is underscoring the importance of telling insurance companies the truth. Any lie you tell an insurance company gives them a potential way to avoid paying a claim.

People who have tried and failed to get control of their spending may be skeptical of yet another book on this subject. Bach begins with identifying your values, hopes, and dreams, and say “It’s my experience that people will do more, and act more quickly, with regard to their finances when they understand how their actions relate to their values.”

In conclusion, the best part of this book is the series of concrete steps designed to allow you to identify what matters to you in life and align your saving and spending with you values, hopes, and dreams. I suspect this approach is better than books that just urge us to spend less and save more. Delaying gratification sounds a lot less fun than making sure you get what you really want in life. But there are a few pieces of advice in this book readers are best to ignore.