Wednesday, July 31, 2019

Trusts, Whether You Want Them or Not

Most of us have heard of wealthy families setting up trusts. We have a vague idea that they’re set up to reduce taxes or provide a controlled income to young beneficiaries. Income taxes on trusts can get complex. But people who set up trusts know what they’re getting into and are usually prepared to pay an accountant. However, as I found out, there’s a type of trust that comes into existence automatically.

When a person dies, their executor must file a final tax return by tax-filing season the next year (or 6 months after death, whichever is later). However, this final tax return only applies to income that arrived before or at the person’s death. There are many easy-to-understand websites that explain these tax rules and basic tax-preparation software can handle these returns.

But what about the income that comes after death? If there is no surviving spouse, it takes a while to distribute assets to beneficiaries. In the meantime, RRSPs, RRIFs, TFSAs, houses, and other assets can produce interest, dividends, and capital gains. Even in the simplest cases, there is usually a $2500 cheque from CPP to cover part of the burial expenses. Someone has to pay taxes on this income.

This is where the trust comes in. After death, the assets in the estate are considered to form a trust. In some cases the executor can get away with having beneficiaries declare the estate’s trust income, but the most tax-efficient way to declare this income is usually with a T3 Trust Income Tax and Information Return.

This is where I ended up after reading dozens of articles on the subject. My sense that it couldn’t possibly be this complicated turned out to be wrong. My late aunt’s estate had 3 slips for a total of $2540 of income. This had me filling out a form with a dozen questions including

“If the trust is a deemed resident trust, is the trust an ‘electing trust’ as defined in section 94?”

“Does the trust qualify as a public trust or public investment trust that has to post information about the trust on the CDS Innovations Inc. web site under section 204.1 of the Income Tax Regulations?”

My aunt’s very simple situation got lumped in with very complex trust arrangements. I filled out the T3 trust return (by hand!) as best I could but got a couple of things wrong. The biggest mistake was filing late. Trusts have only 90 days from year end (end of March) to file. So, this T3 trust return was due a month before the final return.

In the end my mistakes cost a total of $35 in interest and a late-filing penalty. I consider this cost a bargain if it means I’m done with acting as executor. But I have to wonder why this process has to be so difficult.

The most difficult part for me was determining if the T3 trust return was really the correct return to file. CRA’s guide for preparing returns for deceased persons describes returns for rights or things, a partner or proprietor, and income from a graduated rate estate. For a while, I thought I needed to file a return for rights and things. I’d have to rate this guide from CRA “unhelpful” for someone holding 3 little slips.

Surely winding up an average Canadian’s affairs can be simpler while extracting the same tax revenues. It shouldn’t be necessary to hire an accountant to file T3 trust returns for people who just have a few tax slips.

Thursday, July 25, 2019

Canadian ETFs vs. U.S. ETFs

When it comes to investing, we should keep things as simple as possible. But we should also keep costs as low as possible. These two goals are at odds when it comes to choosing between Canadian and U.S. exchange-traded funds (ETFs). However, there is a good compromise solution.

First of all, when we say an ETF is Canadian, we’re not referring to the investments it holds. For example, a Canadian ETF might hold U.S. or foreign stocks. Canadian ETFs trade in Canadian dollars and are sold in Canada. Similarly, U.S. ETFs trade in U.S. dollars and are sold in the U.S. Canadians can buy U.S. ETFs through Canadian discount brokers but must trade them in U.S. dollars.

Vanguard Canada offers “asset allocation ETFs” that simplify investing greatly. One such ETF has the ticker VEQT. This ETF holds a mix of Canadian, U.S., and foreign stocks in fixed percentages, and Vanguard handles the rebalancing within VEQT to maintain these fixed percentages. An investor who likes this mix of global stocks could buy VEQT for his or her entire portfolio without having to worry about currency exchanges. It’s hard to imagine a simpler approach to investing.

Investors who prefer to own bonds as well as stocks can choose another asset-allocation ETFs offered by Vanguard Canada, BlackRock Canada, or BMO. But the idea remains the same: we own just the one ETF across our entire portfolios. For the rest of this article we’ll focus on VEQT, but the ideas can be used for any other asset-allocation ETF.

Why would anyone want to own a set of U.S. ETFs instead of just holding VEQT? Cost. It’s more work to own U.S. ETFs and trade them in U.S. dollars, but their costs are much lower. To see how much lower, we need to find a mix of U.S. ETFs that closely approximates the investments within VEQT. Readers not interested in the gory details of finding this mix of U.S. ETFs can skip the end of the upcoming subsection.

VEQT Breakdown

Inside VEQT is a set of other Vanguard Canada ETFs. As of the end of 2018, here was the breakdown:

  • 39.7% VUN (U.S. stocks)
  • 30.1% VCN (Canadian stocks)
  • 22.8% VIU (foreign stocks in the developed world)
  • 7.4% VEE (emerging market stocks)

Digging into each of these ETFs, we find that VUN just holds the U.S. ETF VTI, and VEE just holds the U.S. ETF VWO. Things are a little more complicated for VIU. The U.S. ETF VEA is very similar to VIU, except that VEA is 8.7% Canadian stocks. So, we can think of VEA as 91.3% VIU and 8.7% VCN.

Sparing readers further calculation details, here is a mix of ETFs with the same holdings as VEQT:

  • 27.9% VCN (Canadian ETF holding Canadian stocks)
  • 39.7% VTI (U.S. ETF holding U.S. stocks)
  • 25.0% VEA (U.S. ETF holding non-U.S. stocks in the developed world)
  • 7.4% VWO (U.S. ETF holding emerging market stocks)

Cost Difference

To decide whether to go with a very simple portfolio of just VEQT or the more complex mix of 4 ETFs, we need to know how much money the more complex approach saves. There are four main factors to consider in this cost comparison: management expense ratio (MER), unrecoverable foreign withholding taxes (FWT) on dividends, trading costs, and currency conversion costs.

Foreign withholding taxes on dividends are likely the least familiar cost for most investors. When we own U.S. or foreign stocks, the U.S. or foreign country may withhold a percentage of dividends which we may or may not get credit for when we file our taxes in Canada. This area can get complex. Fortunately, Justin Bender has a very handy Foreign Withholding Tax calculator that provides most of this information as of the end of 2018.

For VEQT, MER+FWT is 0.495% when held in a TFSA or RRSP, or 0.271% when held in a taxable account. Why the difference? When we file our income taxes, we get credit for paying dividend taxes to a foreign government if the investment is in a taxable account, but we don’t get this credit in a TFSA or RRSP.

For the mix of VCN and the 3 U.S. ETFs, the blended MER+FWT depends on what type of accounts hold the various ETFs. If we keep the U.S. ETFs out of our TFSAs, the blended MER+FWT is 0.132%. This is much cheaper than VEQT for two main reasons. The first is that the MERs of U.S. ETFs are lower than those of Canadian ETFs. The second relates to tax treaties between Canada and the U.S. When Canadians hold U.S. investments in an RRSP, the U.S. does not impose withholding taxes on dividends. However, when we own VEQT in an RRSP, there is an extra layer of ownership and we get charged the U.S. taxes on dividends.

For an investor who has no investments in taxable accounts, the difference in MER+FWT between VEQT and the mix of 4 ETFs is 0.36% per year. However, owning 4 ETFs, 3 of which trade in U.S. dollars leads to currency conversion costs and higher trading costs (when adding new money, rebalancing, and when withdrawing in retirement). Assuming an investor who uses Norbert’s Gambit to keep currency conversion costs down, the extra trading and currency conversion could easily cost $200 per year. This makes the 4-ETF approach cheaper than owning just VEQT by $200 less than 0.36% of the portfolio size.

For an investor with a $50,000 portfolio, owning just VEQT is actually cheaper by $20 per year. At $100,000, the annual savings of owning the mix of 4 ETFs is $160, hardly enough to be worth the added trouble. However, an investor with a million dollar portfolio would save $3400 per year with the 4-ETF approach.

Some might be tempted to say that once you’re a millionaire, why worry about a lousy $3400 per year? Well, if we assume a 4% withdrawal rate at the start of retirement, that million dollars gives only $3300 to spend each month. Sticking with VEQT would cost a full month’s spending every year.

A Compromise

It seems that if we want to avoid wasting a big chunk of our available spending in retirement, we have little choice but to own some U.S. ETFs and handle all the extra trading, rebalancing, and currency conversions. However, there is a compromise.

Why not just start with only VEQT and worry about splitting into 4 ETFs later? For young investors starting from nothing, it could take years to get to a portfolio of, say, $200,000 when the cost savings of the 4-ETF approach start to become worth the trouble.

Even after we sell all the VEQT to buy VCN, VTI, VEA, and VWO, we could still buy VEQT with any new money we add in the future. We could limit the trouble of dealing with 4 ETFs to very infrequent mass switches of $200,000 or more.

Although world stocks tend to move up and down together, it’s possible that our 4 ETFs could get out of balance once in a while. In most cases, it would be possible to rebalance without any currency conversions. We could adjust the level of VCN by trading between VEQT and VCN. We could adjust the levels of the 3 U.S. ETFs by trading among them using just U.S. dollars.


Whether to go with the simplicity of an asset allocation ETF or the lower cost of U.S. ETFs doesn’t have to be an all-or-nothing decision. A careful compromise of waiting until the total amount of VEQT reaches a chosen threshold can get us most of the simplicity along with most of the cost savings.

Tuesday, July 23, 2019

How High are Rents Today?

We hear a lot about how tough it is for young people to afford sky-high rents today. However, many of the articles I read measure affordability of renting for a single person of modest income. When I was young, few young people could afford rent on their own. Most rented rooms in a house or went in with one or two others to cover rent. This left me wondering if rents really are tougher to afford than when I was young.

The last time I rented was decades ago, but I still remember what I paid. Using the CPP maximum pensionable earnings as a proxy for the rise of wages, the townhouse I rented years ago with my wife should cost $1180 per month today. But, a nearly identical place currently rents for $1760 per month.

This is just a single example, but it appears to be typical of rents across my city. Renting now takes about a 50% bigger bite out of wages than it did when I was young.

So, to the baby boomers who remember how hard it was to make rent decades ago and who might doubt that it’s harder now: yes, young people have it tougher today when it comes to rent.

Friday, July 19, 2019

Short Takes: Investing Simplicity, Behavioural Bias Blind Spots, and more

I managed one post in the past two weeks:

Estimating the Value of 0% Financing

Here are some short takes and some weekend reading:

Robb Engen at Boomer and Echo looks at the range of investment options from the point of view of doing it the easy way or the hard way. He finds the right balance of costs and convenience with owning one of Vanguard Canada’s all-in-one portfolio exchange-traded funds with the ticker VEQT. He avoids the troubles and potential mistakes that come with owning U.S.-listed ETFs. However, there is a middle ground. One can own a base of VCN and U.S.-listed ETFs along with some VEQT so that most rebalancing doesn’t require currency exchanges. This approach is still more complex than just owning VEQT, but eliminating most currency exchanges reduces complexity and the possibility of errors significantly. The benefit of this compromise approach is lower costs than just owning VEQT.

Canadian Couch Potato talks to Dr. Stephen Wendel, Head of Behavioural Science at Morningstar, about how we see behavioural biases in others but not ourselves.

Big Cajun Man encountered two-factor security for his banking login, but the security didn’t work out too well. Perhaps this bank is just doing a trial run.

Thursday, July 11, 2019

Estimating the Value of 0% Financing

I recently helped a family member buy a new car. She was paying cash for the car, so we had to estimate the value of the 0% financing offered to figure out a sensible price to pay for the car.

The key factors that matter for estimating the value of low financing interest rates are duration and interest rate reduction. For example, suppose financing is offered for 4 years at a rate that is 4% below a competitive interest rate. This is a total of 4x4%=16%. However, if the car will be paid off over 4 years, the average balance owing will be close to half the price of the car. So, the value of the financing is about 8%.

For this example, you can reduce the car’s MSRP by 8% as a starting point for a cash sale negotiation. This is equivalent to paying the full MSRP and taking the financing. From there you can negotiate down from the adjusted MSRP.

It was interesting to talk to multiple dealerships and take this approach. A couple just pretended they didn’t know what I was talking about. They played it initially like they never heard of financing having a cash value. The place we eventually bought the car from immediately applied a cash-back figure that represented the value of low-interest financing.

A complicating factor was that I made a mistake initially with valuing the financing. I forgot about the average balance owing being only half the price of the car. So, I initially thought the financing was twice as valuable as it really was.

In the end, the price we got appeared to be better than indicated by the somewhat confusing report we downloaded from unhaggle. It’s always hard to know if you got a good or bad deal on a car, and I’m always left feeling uneasy for a while.

I don’t have much advice for most aspects of buying a car, but there are three things I’m confident about. One is how to value low-interest financing, the second is that it’s best to buy from Phil Edmonston’s Lemon-Aid guide recommended vehicle list, and the third is that it’s best to avoid debt and pay cash for cars.

Friday, July 5, 2019

Short Takes: Paying in Home Currency, Rent vs. Own, and more

Here are my posts for the past two weeks:

Switch: How to Change Things When Change is Hard

How Fast Will Your Portfolio Shrink in Retirement?

Here are some short takes and some weekend reading:

Preet Banerjee explains why you should never accept a foreign merchant’s offer to let you pay in your home currency.

Benjamin Felix compares renting to owning a home in terms of unrecoverable costs.

Big Cajun Man can probably hear the circus music after completing another round with CRA. They’ve accepted both halves of his documentation, but not both at the same time.

Tuesday, July 2, 2019

How Fast Will Your Portfolio Shrink in Retirement?

Once you’re halfway through retirement, you’d expect about half your savings to be gone, right? This turns out this is very wrong when we don’t adjust for inflation. The return your portfolio generates causes your savings to hold steady for a while and then fall off a cliff.

I read the following quote in the second edition of Victory Lap Retirement:

“A recent Employee Benefit Research Institute study found that people in the U.S. who retired with more than $500,000 in savings still had, on average, 88 percent of it left eighteen years after retirement.”

Frederick Vettese provided further detail. This 88% figure is the median rather than the average.

This statistic was used as proof that retirees aren’t spending enough. After all, if you planned on a 35-year retirement, half the money should be gone after 18 years, right? Not even close. Below is a chart of portfolio size based on the following assumptions.

- annual portfolio return of 2% above inflation
- annual withdrawals of 4% of the starting portfolio size, rising with inflation each year
- inflation of 2.12% (the average U.S. inflation from 2001 to 2018)

So, to be on track for a 35-year retirement, your remaining portfolio 18 years into retirement should be 83% of your starting portfolio size. This is a far cry from an intuitive guess that about half the money should be left.

Still, the earlier quote said the average retiree who started with at least half a million dollars had 88% of their money left 18 years into retirement. Further, thanks to a reader named Dave who found the original EBRI study online, we know that the 88% figure is inflation-adjusted.

Here is an inflation-adjusted version of the chart above:

So, 18 years into retirement in this scenario, you’d have 57% of your money left after adjusting for inflation. But the median U.S. retiree who started retirement with at least half a million dollars has 88% of the money left after adjusting for inflation. This is so high it would seem that retirees are severely underspending in retirement.

However, we have to look at the definition of retirement used in the study:

Definition of Retirement: A primary worker is identified for each household. For couples, the spouse with higher Social Security earnings is the assigned primary worker as he/she has higher average lifetime earnings. Self-reported retirement (month and year) for the primary worker in 2014 (latest survey) is used as the retirement (month and year) for the household.

So, even if the lower income spouse still works, the couple is retired. Also, because retirement is “self-reported,” we need to consider post-retirement working income. Most people who leave an office job, but make some money part-time doing a different type of work, consider themselves retired. Another significant source of money coming in is inheritances.

All these sources of post-retirement income cause retirees to draw less from their savings in early retirement to allow larger withdrawals later when they stop earning side income. This is true even for retirees who seek the largest steady inflation-adjusted spending level they can get throughout retirement.

Another factor that increases median savings levels is that some retirees have savings is in the millions and have no intention of spending all their money. Many retirees intend to leave a legacy.

If we account for the intention to leave legacies and the fact that many retirees continue to earn some income in the early phase of retirement, the gap between actual inflation-adjusted savings 18 years into retirement (median of 88%) and recommended level (57%) would shrink. How much it would shrink is hard to guess without further data on post-retirement incomes and intentions concerning legacies.

However, median figures hide the range of outcomes. You can drown in a river whose average depth is only 4 feet. These statistics include a very large number of U.S. retirees who are overspending and will run out of money. The EBRI study says that of retirees who started with at least half a million dollars, 18 years later 12% have less than one-fifth of their money left, and 32% have less than half. These retirees are at risk of running out of money before they run out of life.

The Victory Lap Retirement book and Vettese’s article promote the idea that retirees aren’t spending enough. In fact, there is a group who don’t spend enough, and another group who spend too much. We need to find a way to direct different messages to these two groups. Unfortunately, it’s the overspending group that is most likely to take comfort from books and articles claiming that retirees don’t spend enough.