Comparing Alternatives for Where to Invest RRSP or TFSA Contributions

Making a contribution to an RRSP or to a TFSA is not the end of the story. That's the saving step. The cash must then earn a return. What are some options and current returns amongst the different possible types of investments (see previous post Investment Building Blocks - Securities for more explanation)?

Inflation
Inflation surreptitiously eats away at the value of your savings whether or not it is in a tax-deferred RRSP or TFSA. You cannot avoid it. Inflation has been at the lower end of the government's target range of 1 to 3%, coming in at 1.3% in 2009, but the average for the last 15 years or so has been the middle of the range at around 1.9%. It is Bank of Canada policy that inflation be 2%. If your annual return is anything below inflation, you are losing money in real terms, perhaps slowly, but nevertheless surely.

Cash
Leaving the money sitting as cash these days gets interest of 1% or so from major banks, even in a savings account (see rates on CANNEX).

GIC
CANNEX also provides a complete table of rates on offer in registered plans. Rates again are quite low. For locked-in GICs, you can get:

• 1-year: 0.4% from major banks, higher rates up to 2.1% from smaller institutions
• 5-year: 2% from the majors, maxing out at 3.6% from others

Bonds
Returns on bonds include the interest and possible changes in capital value due to changes in default risk and interest rate risk. The longer the maturity, the greater the risk of interest rate increases. The examples below are investment grade bonds. Lower rated bonds will give off greater yields (see previous post Seeking Safety: Assessing Default Risk). An interesting choice is real return bonds of the Canadian government - the low yield is after inflation, in other words, the bond interest and capital is automatically adjusted upwards in line with increases in CPI, so the yield is protected from the ravages of inflation. A quick way to see a good sampling of current bonds and their yields is to go to this page on CanadianFixedIncome.ca.

Sample Yields as of February 2nd

Canadian Government

• 2-year: 1.18%
• 5-year: 2.46%
• 10-year: 3.38%
• 20-year: 4.02%
• 17-year Real Return: 1.44%
  

Provincial Government

• 4-year Ontario: 2.52%
• 8-year Quebec: 3.64%
• 10-year BC: 3.93%

Corporate

• 5-year Royal Bank: 2.88%
• 19-year Bell Canada: 6.22%
  

Bond ETFs (contain various mixes of maturities and issuers)

• iShares CDN Government Bond Index Fund (symbol XGB): 2.85%
• BMO Canadian Government Bond Index ETF (ZGB): 2.59%
• Claymore 1-5Year Laddered Government Bond ETF (CLF): 1.8%
• BMO Aggregate Bond ETF (ZAG): 2.97%
• iShares CDN Corporate Bond ETF (XCB): 3.57%
  

For all types of bonds, get an exact price and yield online through the fixed income section of the brokerage website (the price you pay will be slightly higher and the yield will be slightly less than the CanadianFixed Income figure because the brokerage makes its revenue from the difference since there is no explicit trading commission charged). For less known or popular ones like real return bonds, it may be necessary to phone and speak to representatives at the fixed income desk.

Preferred Shares
There are many individual issues with varying returns, but the dividend yield of the following give an idea of the much more attractive returns available amongst preferreds. See Prefblog for much in-depth knowledgeable discussion of particular issues.

• Claymore S&P/TSX Preferred Share Index ETF (CPD): 5.44%
• S&P TSX Index: 5.49%
  

Income Trusts
Many of the business trusts are being converted to straight corporations or being bought out but many others still remain and their distribution yield remains high (see 2009 post Income Trusts: a Neglected Opportunity?).

• S&P / TSX Income Trust Index: 7.7%
• iShares CDN Income Trust Sector Index Fund (XTR): 9.2%

Equities
Though much or most of the return from equities should come from capital gains, the straight dividend yield of equities, as expressed in the general averages for major markets like Canada's TSX index and the USA's Total Market or S&P 500 remains reasonable. The chance of market declines is the ever-present risk, which investors know all too well.

• iShares CDN Composite Index Fund (XIC): 2.49%
  
• SPDR S&P 500 Index ETF (SPY): 2.0%
  
• iShares CDN S&P 500 Hedged to Canadian Dollars ETF (XSP): 1.59%
• Vanguard Total Stock Market ETF (VTI): 1.77%

The above options are meant as a starting point. They only compare current cash payouts and not the change in value of the investment, which can drastically alter the net investment results both downwards or upwards. Leave it in cash or GICS, there's no risk, just the certainty of slow losses to inflation. As the saying goes, no risk, no reward.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

RRSP vs TFSA vs RESP vs Non-Registered Taxable Account?

This is the time of year when many people get around to making their annual contribution to an investment plan. On January 1st, another $5,000 of TFSA contribution room became available to adult taxpayers. January 1st was also the start of another year for obtaining Canada Education Savings Grants through an RESP. The RRSP deadline for 2009 contributions looms on March 1st.

Are you confused about the choices wondering which is best, or do you have limited means and need to choose whether money goes into a TFSA, RRSP, RESP, or perhaps even a non-registered taxable account? Read on for the rules of thumb on which makes most sense under what circumstances.

1) Contribute to Registered Accounts before a Non-Registered Taxable Account

• tax-sheltered compounding growth in registered accounts is their dominant differentiating advantage. Read The Retirement Savings Debate: Inside or Outside the RRSP Structure? from Philips Hager & North in which they tested and calculated after-tax returns. The Department of Finance reached the same conclusion comparing the TFSA vs a Non-Registered Account. The TFSA, the RESP and the RRSP all take advantage of tax-free growth. The longer the saving and investing period, the more years before the funds will be used, the stronger the effect of tax-sheltering on net, total after-tax wealth for the investor.
• no requirement to track the cost base for tax purposes in registered accounts avoids some administrative hassle and is a minor advantage
  

2) Non-Registered Taxable Account is Best for:

• when registered account contributions have been maxed out
• as PH&N note, beware of unequal comparisons where some people have claimed an advantage for the taxable account - like using borrowing to invest, which introduces substantial investment risk, not reinvesting the RRSP tax refund, which leaves out a key component of the calculation and assuming unrealistically-low tax rates on the taxable account.
  

3) Put the First $2500 into the RESP (assumes higher education is one of your goals)

• the free (if used for education) CESG money provides the superior return, as shown in RESP vs RRSP - the Best Approach is Clear on the CanadianFinancialDIY blog

4) TFSA is Best for (see TFSA vs RRSP - Best Retirement Vehicle? by Ed Rempel on the Million Dollar Journey blog):

• low income earners, especially those under $40,000, and who stay there throughout their life
• rising income, e.g. those early in their career whose incomes will rise with time or; those who expect a large inheritance that will boost their investment income; the general idea is those for whom the tax rate on withdrawal will be higher than when they contribute are best off in a TFSA
  
• very high income earners of $110,000+ (but with either very low retirement savings (under $250k, including pension value, at point of retirement), or with a substantial pension savings amount i.e. over $750k in total value
• prone to spend RRSP tax refund - to get max RRSP effect you must reinvest the refund
• plan to use TFSA as an emergency fund - TFSA withdrawals can be replaced later, i.e. the contribution room is not lost, as is the case with RRSPs
• spouse with low or no income - TFSA enables immediate investment income splitting with spouse, since contribution to spousal TFSA never triggers income attribution back to contributor, but an RRSP has significant such restrictions; a no-income spouse would not earn RRSP contribution room to use anyway.
  
• retired but with excess income - i.e. a place to park funds for tax-free growth; this is unlike RRSPs, which must must converted to RRIFs or annuities by age 71 and which means withdrawals / paying tax on income, with no contributions allowed (see Fiscal Agents' Income-Splitting Opportunities and the Income Attribution Rules that May Prevent Them)

5) RRSP is Best for:

• lower income and/or tax rate on withdrawal; withdrawals are usually lower during retirement, but not always
• income earners in the $40,000 to $50,000 range and $75,000 to about $90,000 (see CD Howe Institute's Saver’s Choice: Comparing the Marginal Effective Tax Burdens on RRSPs and TFSA)s
  
• high income earners, the higher the income, the greater the advantage - true partly because of the higher tax rate being avoided through the contribution along with the tax-free compounding of the amount deferred and partly due to the higher contribution limit on RRSPs ($21,000 in the 2009 taxation year), which allows you to save more
  
• investment income splitting with spouse during retirement - after maxing out splitting using TFSAs
  
• helping stick with regular saving and not withdrawing un-necessarily or prematurely - the idea of losing RRSP contribution room, or paying taxes on withdrawals before retirement may help avoid dipping into it for discretionary spending; conversely the attraction of the tax refund can help motivate the contribution and the saving that represents.

Handy RRSP vs TFSA Estimation Calculator at TaxTips.ca - enter your own data for your province to verify your specific situation.

6) Taking a Loan to Make the RRSP Contribution Works if,

• tax refund is either reinvested or used to pay down the loan - NOT spent (see RRSP Loans: What to do and Not to do and RRSP Loans: and Another Thing - Timing is Crucial on CanadianFinancialDIY)
  

A Useless Tactic
Contribute to RRSP then Put Refund in TFSA - this does no harm but has zero net value as Is the RRSP Refund as Contribution to TFSA Dipsy-doodle Worth It? on CanadianFinancialDIY explains.

If a choice must be made, then the above can provide a guide. If adequate money is available to fill up the best option, then obviously it is possible to go to the next best for greater savings e.g. if the TFSA or RRSP limits are used up, then go for the other, there are still big tax benefits to be had.

Disclaimer: this post is my opinion only and should not be construed as investment or tax advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a tax professional.

ETF Comparison: USA Total Market Equity

The United States is the world's largest equity market and it merits a place in every Canadian investor's portfolio.

The S&P500 is NOT the US Stock Market
The US stock market benchmark is usually taken to be the S&P 500 and that is basically the contents of funds available in Canada on the TSX to the Canadian investor. The S&P 500 is however, a group of large, dominant US companies and does not truly represent the whole of the US equity market - about 4500 smaller companies are missing, which comprise about 20% of the total US equity market value. Smaller company stocks (small capitalization or small cap) behave differently and often outperform those of large companies - e.g. see the Google Finance chart image below which shows US-traded ETFs for small cap (Vanguard's offering , symbol: VV), S&P 500 (symbol: SPY) and total market (symbol: VTI). As VTI's performance suggests, owning a total market fund can be a worthwhile ETF to own.


US Total Market ETFs - the Contenders

1. Vanguard Total Stock Market Index Fund (Symbol: VTI) - the ETF that has attracted the most investor money by far, more than all other entrants combined. Has the largest number of holdings at 3420 and simply buys every company in the index in its market cap proportion, the so-called replication technique.
   
2. iShares Russell 3000 Index Fund (IWV) - another well-established fund, it is the second largest and also replicates its index, which is different and smaller than VTI's.
   
3. iShares Dow Jones U.S. Total Market Index Fund (IYY) - another offering by iShares, it uses a different index containing the most companies; instead of replication, it uses the sampling technique, in which they take a representative sample of companies, to track the index
4. SPDR Dow Jones Total Market ETF (TMW) - despite being the oldest total market ETF by a few months and being offered by ETF leader State Street Global Advisors, and seemingly doing its index-tracking job well, it has not caught on to the extent of the top three funds and has attracted low net assets.
5. Schwab U.S. Broad Market ETF (SCHB) - the baby of the class with a November 2009 launch, it has built a low but reasonable asset base, perhaps because it has the lowest expense ratio of all at a tiny 0.08%
   

Key Comparison Factors (click on table below for details):

Similarities abound amongst these funds:

• passive index tracking - they all seek only to mimic the results of the overall market, not to outsmart and outperform and they thus limit trading only to times when the index changes, which in turn keeps trading commission costs down and realizes fewer capital gains that an investor would have to pay taxes on (see previous post on the Mystery of Fund Capital Gains in 2008 Explained)
• low expense ratios - every ETF has an expense ratio of 0.2% or less, which is outstandingly good, keeping investor costs down and net results higher
• low variation of market price from Net Asset Value (NAV) - all the ETFs have a very tight link between the price of the ETF on the market and the sum of the company shares held, which is exactly what should happen - you can be assured of buying or selling the ETF for what it is worth
• low bid-ask spread - the difference for all these ETFs is typically a cent or so, which equates to 0.1% or less a cost to the investor (see The Bid/Ask Spread and Market Making at InvestorHome for an explanation of how this is a cost to the investor)
  
• holdings concentration and by sector - their main holdings are more or less the same companies and in the same proportions by industry sector, which is no surprise since they aim to mimic the same thing; the number of holdings does vary a lot, ranging from only about 1000 in TMW to over 3400 in VTI. The sampling technique of the smaller funds to reproduce the overall index with fewer total holdings seems to work very well.
  
• returns - the same to a fraction of a percent annualized, again not surprising considering their common aim
  
• distribution frequency - all give out cash on a quarterly basis
• taxes - all distributions from these US ETFs, including any capital gains, will be taxed in a Canadian investor's hands as ordinary income. The good news is that such passive index ETFs will generate almost no capital gains from their internal trading, which is the reason they are described as being extremely tax efficient (see the excellent PriceWaterhouseCoopers Understanding the Tax Implications of Exchange Traded Funds report found on the ByloSelhi website).
  

Management Expenses (MER) - SCHB's is lowest by a hair at a phenomenal 0.08%, over Vanguard's 0.09%. The others are very low at 0.2%

Performance - the market performance results are so similar that one cannot tell the ETFs apart over the past five years on this Yahoo Finance chart of the first four ETFs. Despite using different indexes, they seem to be very good substitutes for one another.



Which ETF is Best?
It is only by getting out the fine tooth comb that one can detect an advantage by VTI. Its five-year compound annualized total return, which includes distributions, edges out the others at 1.98% compared to 1.81% for the next best IYY. It's hard to tell for sure but the lower expense ratio is likely the reason. The comparison table highlights in green the boxes where VTI is slightly ahead of the others.

Whatever your preference, all these ETFs are very good choices in my view.

Caveats: Morningstar discusses a few considerations Canadians should take into account when investing in US-traded ETFs.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.

Market Efficiency: Implications for the Individual Investor

How many times have you read that the stock market is efficient and that therefore you cannot beat the market? What do such statements mean and what are the investing lessons for the individual?

Academic researchers, beginning with Eugene Fama in the mid 1960s, set out the Efficient Market Hypothesis as the notion that stock prices at any moment reflect all available information. The information can include, first, past stock prices, second, all publicly available published data such as accounting reports, analyst reports, news, economic forecasts or anything else that might affect the price, and third, all insider information known only to company executives. The hypothesis states that prices adjust instantly when new information comes out. Since new information is unpredictable, prices are as likely to go down as up, leading to the oft-seen statement that prices follow a random walk.

The conclusion drawn by many is that trying to find winners by active stock picking is a lost cause and the individual investor should simply buy and hold passive index funds. Passive index investing through ETFs or mutual funds is certainly one viable course of action, especially for those who want to spend little time and effort and are content with average market returns, which are usually positive over the long run, though not perhaps in any given year e.g. 2008!

Is there no further possibility? Many believe incorrectly that there is no hope for any investor to outperform the market and that prices are as correct as they can be at any moment. But there is hope and to see why, the key is to understand that efficient markets do not imply that all stocks are correctly valued at all times. Efficient markets only require that prices be fair and unbiased, meaning that they are as likely to be too high as too low. Prices can also deviate enormously from true values. The very mechanism that brings about market efficiency is the action of investors in detecting bargains and investing in schemes to profit. Inefficiencies and mis-pricing are constantly springing up to be devoured and eliminated by investors.

It is best to measure how efficient markets are (and different markets like the NYSE and the TSX are likely to vary in efficiency), and not say that they are black or white efficient or inefficient. A neat summary of Market Efficiency by NYU finance professor Aswath Damodaran tells us the key features that contribute to efficiency - more accessible, reliable and voluminous information; lower transaction costs, higher liquidity and trading volumes, practicality of trading. The opposite conditions mean inefficiency that can be exploited for profit.

Research tests of market efficiency have also uncovered several anomalies: small firm stock returns outperform those of large firms in January; less liquid / less traded stocks and those not widely held by large institutional investors outperform their opposites (which more or less equates to small firms); firms with low accounting book-to-market ratios outperform. Such anomalies signal possible investing strategies for the individual, even allowing that markets have a high degree of efficiency.

Widely followed, highly visible large companies on major exchanges are unlikely
to give the individual investor the best opportunities to make significant excess profits. Instead, the best place to search is amongst the neglected, the less-known where there are fewer of the highly skilled professional institutional investors against whom the individual investor must compete.

Efficient Market Implications:
1) Best Investing Possibilities for Outperformance by the Individual Investor:

• smaller companies - do a sort by market cap size and pick the low end
  
• companies with little or no analyst following - most discount brokers show analyst ratings so focus on companies with no ratings
  
• companies with low trading volume - check the trading volume on the market info about a stock
• January - do your buying then, especially at the beginning of the month
• companies with low book-to-market ratios - this does not mean every such company will experience good returns, many are real dogs
• emerging markets - where information is harder to obtain
• what you know - popularized by Peter Lynch in his classic book One Up on Wall Street, the idea is that the average person may be able to have an information advantage over even the pros in a specific sector or about a specific company

2) Where Outperformance is Unlikely

• technical analysis and the detection of patterns in stock price movements alone has, unfortunately, never proved successful in any proper examination so this is likely not a good method to look for excess returns
• large companies in highly efficient markets of developed countries - USA, Europe, Canada; passive index funds are a surer route
  
• one stock only is very risky; diversify - even the best stock pickers amongst the professionals have some losers amongst their big winners so it is unwise just to have one or two holdings; against this is the fact that in-depth knowledge becomes impossible with dozens of holdings. It is a trade-off and there is no perfect guide.

The suggestion that the above areas are the more promising does not mean that automatically any such stock is a good buy. The due diligence collection and analysis of information is essential to realizing those better odds.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

The Annual Investment Review: Part 2 - Tax Matters

The preceding post contained suggestions for an annual review and revision of investing goals, performance, savings and withdrawal rates, portfolio structure and rebalancing. This second post completes the proposed annual review by listing some ways where income taxes can enter into plans for the coming year.

Tax-related actions aim to help save on taxes in the short or long term. Actions to consider:

• RRSP catch-up contributions and loan - pull out the CRA's confirmation letter from last year's tax return to see how much RRSP room you have; if there is too much room for your cash on hand, this might be an especially favorable year to take out a loan to do the catch-up since RRSP loan rates are as low as 2.5 to 3.25% at some financial institutions. RRSP loans generally pay off if either the loan is repaid within a year or if the tax refund from the contribution is reinvested, as CanadianFinancialDIY analyzes in RRSP Loans: What to Do and Not to Do.
• Charitable donations through donation in kind of securities with capital gains, since there is no capital gains tax to pay on in-kind donations, as opposed to selling shares and having to pay tax on gains, or to using cash on which income tax has already been paid. CanadaHelps.org even provides a convenient online service to make the in-kind donation to virtually any registered charity in Canada.
• Loan to a lower income spouse for him/her to invest, due to the current low level of interest rates that CRA accepts (1% as of 4Q09 - see CRA page updated once per quarter). TaxTips.ca's Income Splitting discusses ins and outs, pros and cons.
• Create pension income by converting an RRSP into a RRIF - At age 65, if not receiving $2000 of pension income from other sources, consider converting enough of RRSP or LIRA to a RRIF to obtain the pension tax credit as TaxTips.ca describes in detail.
• TFSA contribution - another $5,000 in contribution room for has become available for all taxpayers as of January 1st (to which can be added $5,000 for 2008 if no contribution was made last year), providing another opportunity besides the RRSP for investments to grow tax-free.
  
• RRSP/LIRA Conversion to RRIF/LIF at age 71 - if this is the year you turn 71, then the conversion must take place by Dec. 31, 2010, or else nasty penalties apply, so it is good to note and plan for this at the start of the year (see TaxTips again for details).
• Fixed Income in Tax-Sheltered Accounts, Stocks in Taxable Accounts - to the extent possible when you have multiple accounts and within the target asset allocations, fixed income investments that produce primarily interest should be in TFSAs, RRSPs and other types of tax-sheltered accounts, while a taxable account should contain equity investments that create dividends and capital gains.
• RESP Contribution - the new year for investing tax-deferred money to fund higher education and to obtain the government's CESG grant of 20% on contributions up to $2500 for 2010 was January 1st. The earlier the investment is made and the grant is received the longer the funds have to grow sheltered from tax.
• RRIF & LIF Withdrawals - the dollar amount for the 2010 withdrawal minimum (for RRIFs and LIFs) and maximum amounts is set by the standard percentages applied to the year-end account balance. It helps the year's planning to see early on when year end statements are available what those amounts will be.

That's a fair amount to keep the DIY online investor busy but the effort is worth it in taking advantage of all the opportunities as early as possible and making life easier throughout the year.

Disclaimer: this post is my opinion and for information only and should not be construed as investment advice or recommendations. Nor is it to be taken as tax advice, merely information to get started. To be sure, consult an accountant.

The Annual Investment Review: Part 1 - Review Goals & Performance, Rebalance

At least once a year, it is a good idea to take stock of progress on investments and plan any required adjustments. The beginning of a new year offers a convenient time since account statements and year-end market statistics are available for review, and since many funds and ETFs distribute cash that can or should be reinvested and new contributions to RRSPs and TFSAs may be made. Here is a suggested process to follow. This first part deals with general investment planning while the second part to follow talks about tax-related matters.

1) Review Investment Goals
Are the objectives set in your plan (see Setting Investment Objectives post on how to do this) - retirement, house purchase, vacation, vehicle, education etc - still valid as to dollars required and timing? A new child, a death, an illness, or some other life event may trigger changes to financial priorities and the investment plan must adjust. Money that will be needed within the next few years should be in highly stable, secure and liquid forms. like cash, money market funds, T-bills, or perhaps GICs if the spending date is far enough away and fixed.

2) Tally Performance and Total Savings or Withdrawals The next step is to see how the year has gone towards meeting investment goals by taking all year end account statements (RRSP, Regular taxable, LIRA, TFSA etc) and summing account value. The grand total portfolio is what matters not the performance of individual holdings or accounts. Compare 2009 not just against 2008 since the huge down then up swings cannot give an accurate picture of the longer term trend. Go back four or five years to compare.

For people in savings mode, there should be an increase, perhaps not since 2008, but certainly since 2005. One way to benchmark is to compare your own portfolio performance with those of simple, standard portfolios, as described in this previous post. Refine this by removing inflation to see if there has been a real after-inflation increase (get inflation figures from the Bank of Canada Inflation Calculator). Check also the net contributions to accounts against what was planned in last year's review. The idea is to decide how much you need to put aside in the coming year to attain goals and to make adjustments to current spending and savings rates.

For people in retirement pulling money out of accounts, multi-year totals that show the portfolio increasing are very reassuring as that indicates long term sustainability. Where there is a net portfolio reduction, the key is to have kept the amount of withdrawals as close as possible within the sustainable rate e.g. for a portfolio to last indefinitely, taking out about 4% a year is sustainable as this previous post discusses.

3) Alter Portfolio Structure (if required) Major changes to financial fortunes or life circumstances during the past year may either increase or decrease the capacity to take on investment risk and consequently the mix of investments. A large inheritance may suggest a shift to a more stable, less risky and lower return portfolio since higher returns are no longer required to reach investment goals. A new job with a high salary, enabling a higher savings rate, but which is in a volatile sector, may also suggest a shift to a lower risk portfolio with no connection or correlation to the industry of the job.

4) Rebalance Portfolio to Target Asset Allocations The next step is to plan the purchase and sale of securities in the portfolio to get back to the target allocations as originally set up, or as newly modified. Previous posts on Asset Allocation and on Rebalancing discuss this in detail and give examples of how it is done.

Rebalancing can be quite simple during saving and investment accumulation years. During retirement years, when cash is being withdrawn, it need not be much more complicated. A portfolio can be designed from scratch to produce income - see the example in Generating Cash form the High-Yield Couch Potato Portfolio. Or, it may be done as part of asset allocation - see Generating Cash with Global Couch Potato Portfolio.

Disclaimer: this post is my opinion and for information only and should not be construed as investment advice or recommendations.

Company Risks - Pension Plans and the Z-Score

Bankruptcies and underfunded pension plans are painful not just for pensioners but for investors too. Pension plan underfunding is one company risk indicator that an investor should examine closely. Underfunded pension obligations that become too onerous may cause a liquidity crisis in a weakened company and may be a catalyst for bankruptcy. Companies are obligated to make up pension underfunding with extra catch-up payments, which can harm the company's chance of survival. Westlaw's Bankruptcy Risk: Pension Underfunding in Overdrive describes the difficult situation in some of Canada's best-known companies like Air Canada and AbitibiBowater.

Recently, Rob Gerlsbeck at MoneySense evaluated the status of pensions at 181 public Canadian companies in The Top 22 Pensions in Danger. His table (which can be downloaded as a spreadsheet for further sorting and filtering) uses two very useful figures to assess pensions in danger: the percent underfunding (pension plan liability vs pension assets) and the Altman Z-score, which estimates the risk of near-term bankruptcy using accounting figures. This table can help an investor screen in, or out, potential investment targets.

The Altman Z-score is a reasonably reliable predictor of company bankruptcy according to the Wikipedia article on the subject but extensive lists where the calculation has been done are not readily available to the online investor. Investopedia's Z Marks the End walks through the example of how the Z-score foretold of trouble at WorldCom and discusses limitations of the metric. To do one's own Z-score calculations, there is an online calculator at CreditGuru, or one can build one in a spreadsheet with the formula. The required accounting data is found in company financial reports.

The crash of 2008 hit pension plans hard through lowered values of the shares which comprise much of the assets of such plans. The recession added to stress on company operations and drove some famous names like GM and AbitibiBowater into bankruptcy. There has been modest recovery in pension solvency during 2009 along with the stock market but the federal pension regulator, the Office of the Superintendent of Financial Institutions, said that the average solvency of the 400 plans it monitors rose only from 85% in December 2008 to 88% in June 2009. This is still lower than any other point since 2003.

Averages cover a wide range of individual company situations, from the desperate like Extendicare REIT, to the extremely solid like Corby Distilleries, as the MoneySense table shows. Further digging may also reveal a different picture, such as the fact that Zarlink's pension plan, though unfunded and described as in danger by MoneySense, has been protected in other ways as CanadainFinancialDIY writes. Investors, like pensioners, need to monitor this risk hot spot when buying or selling stocks.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.