Friday, June 19, 2020

Short Takes: Billionaire Bashing, Asset location Debates, and more

A promoter sent me a press release announcing that billionaires increased their net worth by $584 billion since the start of the pandemic.  I guess I’m supposed to be outraged that they profit while everyone else suffers with job losses, sickness, and death.  Coincidentally, the “start of the pandemic” lines up with the bottom of the stock market crash.  If we use VTI as a proxy for billionaire wealth, these investors lost about $780 billion in the month before the pandemic started.  Suddenly the outrage melts away.  I’m all for improving equality of opportunity, but I don’t see how this misleading garbage will help.

Here are my posts for the past two weeks:

Questions for Your Financial Advisor

Borrowing to Invest

Here are some short takes and some weekend reading:

Justin Bender
completes his podcast series of 4 portfolios with different asset-location strategies.

Robb Engen at Boomer and Echo says that asset location isn’t worth worrying about.  I certainly agree with this conclusion if we are talking about the typical poor asset location advice telling us to put bonds in RRSPs.  This advice comes from a schizophrenic analysis that assumes tax rates are zero when calculating asset allocation, but tax rates suddenly take on realistic values when assessing investment performance.  It makes more sense to judge the value of strategic asset location based on a sensible strategy.  Roughly speaking, such a sensible strategy takes assets in the order U.S. stocks, international stocks, Canadian stocks, and bonds, and then fills accounts in the order RRSPs, TFSAs, and non-registered accounts (some variation may be needed depending on tax rates, account sizes, and position sizes).  Not worrying about asset location is certainly easier, which is valuable.  In my own case, I find that using strategic asset location simplifies my portfolio somewhat because each of my accounts has fewer holdings.  This reduces the number of trades required for deposits, withdrawals, and rebalancing.  I simplify further by not holding strictly to optimal asset location when small deviations reduce the number of trades I need to perform.

Big Cajun Man
tells us what to do with found money.  If you follow his advice, your future self will thank you.


  1. @Michael, when it comes to bonds, I'm going to ignore non-registered accounts for now -- they are the worst place for bonds due to lack of preferential tax treatment on them. But between RRSP and TFSA only, here's my thinking on bonds; I'd appreciate your thoughts on what I might be missing.

    I would think the RRSP is the place to put them. My reasoning is that the "magic" benefit of the RRSP is the difference between marginal tax rate of contributions minus the average tax rate of withdrawals. So minimizing the tax rate of withdrawals is one aspect of maximizing the RRSP benefit. There are certainly different aspects to minimizing tax paid on RRSP/RRIF withdrawals, but one aspect is having less money to withdraw in the first place. So I would think constructing a portfolio to minimize the expected rate of return in the RRSP portion and maximizing the rate of return in the TFSA portion is a good idea.

    I know this is complicated and there are many factors when it comes to other asset classes and how much room is available in each type of account. For example you certainly want to avoid US exposure in TFSA's due to unrecoverable withholding taxes on dividends. But if you can fill your TFSA with Canadian and Canadian-based International holdings (the good kind of international holding that holds international securities directly and doesn't just hold a US-based international ETF under the hood), then doesn't bonds in the RRSP make sense?

    I have a feeling I'm missing a key angle to this!

    1. Hi Returns Reaper,

      Let's suppose for a moment that you know all your RRSP/RRIF withdrawals will be taxed at 40%. Then no matter how your investments perform, exactly 60% of all gains will become your after-tax money to spend, and 40% will go to the government. The best way to think of this is that your current RRSP is 60% yours, the rest belongs to the government, and your share grows tax-free. Note that your tax rate when contributing isn't relevant, and that this way of thinking would apply for other percentages than 40%.

      Understanding things this way, we see that maximizing returns within the RRSP is a good thing. In fact, assets in your RRSP begin to look very similar to assets in your TFSA (tax rates matter for which to contribute to, but once money is in both, they look similar in terms of how gains benefit you). Avoiding U.S. dividends in TFSAs is an exercise in maximizing gains within each account, but the benefit of any gains you achieve look similar between the accounts.

      One way that reality differs from this view of the world is that if your RRSPs perform extraordinarily well, part of your withdrawal tax rate would rise to a new tax bracket. For the most part, this is a minor concern in any analysis.

      Any logic that leads to minimizing RRSP returns amounts to worrying about the government's share of your RRSP. Here's a thought experiment. Suppose a genie offers to increase your RRSP assets by a $100,000. Are you happy with the extra $60,000 that is yours, or are your furious that the government will get another $40,000?

      I'm only concerned with my after-tax returns. If I only cared about the amount of tax I pay, I'd keep everything in cash, so I'd have no returns and would pay no tax.

      At its core, people tie themselves in knots thinking about this stuff because they fail to see that their RRSPs aren't entirely their own money. With a purely after-tax view, if I have non-registered investments, I'd rather they were bonds than stocks, because bonds generate lower returns, and the higher taxes on non-registered investments would harm me less.

    2. Hi Michael, I think it is your first statement in your response that I think deserves a bit more examination. Your analysis assumes a fixed percentage belonging to the government. In fact, the amount that belongs to the government will depend on your income in retirement. The larger my RRSP grows, the larger my minimum withdrawals will be after conversion, and therefore the higher my income will be. Higher incomes mean higher tax rates, which means that the larger my RRSP is the larger the percentage is that the government owns.

      I'll be honest, I haven't done any deep analysis on this to try to quantify this effect. It could be so minimal that it isn't worth it. I'm only now getting close to the point where I am considering adding bonds to my portfolio so it hasn't been a huge focus.

      But back to your genie question. Let's modify it a bit and ask me to pick between plumping my RRSP account by $100k or my TFSA by $60k (based on an assumption of a 40% average tax rate on the RRSP account *before* the genie windfall). In this case, I'd tax $60k in the TFSA, because I anticipate the 100k in the RRSP will cause the RRSP average tax rate to increase above 40%.

      Again, given I haven't carefully analyzed this, maybe the difference is so small it barely moves the needle and isn't worth considering. It's also tricky to analyze in depth because of wonky effective tax rates in retirement (considering GIS clawbacks, OAS clawback, and a couple of other benefits or clawbacks I'm sure I'm forgetting at the moment). So it ends up looking very different for everyone depending where they are and will be in various marginal tax rate brackets. In addition, it's hard to know how that landscape will change by the time retirement hits. But I think it is a safe bet that generally (once you get past the GIS clawback) effective marginal tax rates will only go up as income goes up.

    3. Hi Returns Reaper,

      There are many complexities, and short of doing a full-blown simulation taking into account all factors over the coming decades, we have to make decisions based on a simpler model. A simple model that gets us close to correct answers is to estimate a fixed tax rate and treat RRSPs as belonging partially to the government.

      When we imagine the effect of an extra $100k in your RRSP, if we estimate $4k/year of extra withdrawals, the bump in overall tax rate is modest (assuming that other part of the annual withdrawal is much larger).

      The other side of this way of thinking is that you should factor out the government's part of your RRSP when you calculate your asset allocation. So, $100k of CDN stocks in a TFSA plus $250k of U.S. stocks in an RRSP is a ratio of 100:150 rather than 100:250 (based on a 40% tax rate estimate).

      A lot of people trying to justify different analyses that lead to having bonds in RRSPs like to say that future tax rates are uncertain so we shouldn't try to forecast them. However, they are implicitly assuming a 0% tax rate. This is much further off the mark than a guess of 40%.

  2. Hi Michael,

    I appreciate the discussion! I hope I'm not tiring you out on this one...

    I completely agree with your statement that some estimate of after tax value should be used for comparing weights of positions within a greater portfolio. I do this myself. I've discussed this with a few people I consider to be very smart people and cannot get them to agree on this point. I'm not sure how the point of the only thing that matters is a dollar you get to spend vs. a dollar that is subject to tax. But at least we agree!

    You're also right, a full simulation of all scenarios is required to state what is correct for each individual scenario. But for the purposes of advancing the thought on this, I think it is fair to say that the "right" fixed amount the government takes is the future average tax rate that will be applied (which is difficult to know what it will be). *If* the marginal effective tax rate is higher than the average, then, generally, there will be *some* penalty to asset location decisions that result in a larger RRSP vs. TFSA.

    Due to complex marginal effective tax rates in retirement (due to things like GIS, OAS, and age amount clawbacks), it is far from simple as there are many cases where marginal rates are lower than average rates in retirement, which is generally not true pre-retirement.

    So, ok, let's say this is complicated, and we won't rush to make a general statement true for everyone. But suppose you are sure that in your situation your marginal tax rate in retirement will be higher than the average tax paid on your RRSP withdrawals. *If* that is true, I think, all else equal (which is a key point because everything else is *not* equal due to things like withholding taxes, and...?), you want to favour growth in a TFSA over an RRSP.

    I'm not sure if you have a post on it somewhere, but I'm curious was bonds are so lowly rated to go in the RRSP. If I was considering only RRSP and TFSA's, I would have said the order of putting asset classes into various types of accounts would be to take:
    U.S. stocks, bonds, International stocks (the good kind without extra withholding tax penalties) and fill RRSP and TFSA.

    The difference between your list and my list is that bonds and international stocks are swapped. What is the benefit of international stocks in an RRSP vs. TFSA, assuming the international holding is a Canadian denominated ETF that holds international securities directly such that there is not an additional 15% withholding tax on the dividends?

    *If* putting international stocks in my TFSA meant additional dividends, I would immediately change my tune and agree that such a penalty would surely wipe out any very small change in less taxes paid due to less growth in RRSP vs. TFSA.

    I definitely admit the less taxes paid effect does *not* apply to all incomes. For incomes including RRSP income that are fairly low, slightly after the GIS clawback is done, effective marginal tax rates are well below average RRSP tax rates meaning additional dollars withdrawn from the RRSP are lowering the "fixed" percentage that is the governments.

    Again, thanks for the detailed discussion!

    1. Hi Returns Reaper,

      I've been arguing about this issue with advisors whose clients are fairly wealthy. The debate is whether bonds should go in a non-registered account or in a tax-sheltered account. These people consider TFSAs to be mostly irrelevant because they hold comparatively little. So, when I or others talk about putting bonds in RRSPs, we generally mean as opposed to a taxable account. My contention is that for a given after-tax asset allocation (ATAA), it's better to tax shelter higher-yielding investments. When I try to give a short description of how to do asset location, it is often with the preceding in mind.

      For the investor whose savings all fit in RRSPs and TFSAs, the situation is much simpler. Apart from having U.S. dividend-paying assets in RRSPs, other considerations are fairly small. Having bonds in an RRSP is likely slightly better than having them in a TFSA for the reasons you described, as long as the rule about U.S. assets isn't broken.

      As is often the case when reasonable people disagree, they find they're actually talking about different things.