Investing for Children: Getting the Goal and Timing Right for Education

A successful plan to invest for a child's post-secondary education must address:

• the cost of the education
  
• the timing of the studies to determine when funds will be required
  
• the variability of various types of investments and their respective returns in the short and long term - stocks do best over long periods but may suffer severe ups and downs in the short term

Total Cost of Education
Develop an estimate of how much you will need to save using the excellent Investored.ca Calculator, where you can enter many variables such as: number of children, current age, duration of post-secondary program, age to start post-secondary studies, live at home or in residence with or without meal plan with actual recent costs for tuition for both college and university and room and board by province. You can select to add in or not the Canada Education Savings Grant.

Timing of Spending
18 years is the usual youngest age when post-secondary education starts, but it can be delayed which may warrant keeping more of the investment assets in more volatile stocks longer. This is a difficult call since young people can change their minds quickly and decide suddenly that they do want to go back to school after all. Such delightful news to a parent should not be marred by discovering that the stock market is in a downturn and the required funds are less than a year previous. There does come a time when the education goal, having not yet been pursued, becomes unlikely and it is best to shift investment goals.

Higher education lasts two to four years, perhaps longer if higher, higher education is pursued. The cash needs to be made available over that span, so investments that mature in time with each new school year make sense.

The Time-to-Spending Asset Mix
The longer there is before the funds will be needed, the greater the proportion of the investment asset mix should be in stocks, which provide higher long term returns than bonds, GICs, money market funds or plain old cash earning interest. One critical caveat - if a large lump sum (like an inheritance) sufficient to fully fund any higher education comes along, then merely protecting that capital against loss and inflation may well be the wisest approach. Most people do need to take advantage of higher stock returns (e.g. 4.5-7% for stocks vs 2-4% for bonds vs 0-2% for T-bills; see these summaries of past and future expected returns at CanadianFinancialDIY and the Bogleheads forum)

Example Asset Mix Over a Childhood
Birth: 80% Equity & Other, 20% Bond
Age 13-14: Child still headed for higher education?

• Yes - shift to 40% Equity, 40% Bond, 20% Cash (incl GIC, Money Market Funds, T-bills)
• No - maintain asset mix to serve different long term goals (e.g. house purchase)

Ages 15-18, assuming still headed for higher ed

• Shift another 10% a year into Cash till it is 100% Cash

Variations of the percentages and ages of shifting are possible but the idea is that as the time for spending approaches less and less should be in riskier, more variable investments and more in the stable, safe, liquid investments.

Corporate Bonds for an RRSP or TFSA in 2009 - an Opportunity?

Investors may be wondering what to buy in the new Tax-Free Savings Account (TFSA) that started up January 1st or in their RRSP account. One intriguing possibility right now is corporate bonds. Why?

1. Tax - the tax-exempt status of the TFSA or the tax-deferred RRSP makes it reasonable to hold within them such bonds, since they produce income in the form of interest, which is taxed at highest marginal rates
   
2. Higher Returns Than Usual - compare current rates

• Cash deposit rates of about 2% and 5-year GICs of 2-3% (see rates on Canoe)
  
• Government of Canada bonds at just over 2%,
  
• Yields on bonds of the highest-rated corporations > 4%, e.g. Bank of Montreal as of February 5th maturing April 30, 2014 yields 4.2% (see rates for 2014 maturity on Canadian Fixed Income).

The credit crunch crisis that started in 2007 and reached a peak in October 2008 caused severe market dislocations and has created this potential opportunity.

The chart below of two ETFs that track Canadian government bonds (iShares XGB on TSX) and corporate bonds (XCB) illustrates a dramatic change in relationship.

Up to mid 2007 the price of the two funds closely followed each other. Then XCB began to fall - a fall in bond prices means the yield has gone up (see Investopedia's Bond Basics: Yield, Price and Other Confusion) and now there is a huge gap. The lower the quality of the bond (as measured by ratings of bond rating agencies such as Standard and Poors, DBRS and Moody's, the higher the yield. Lower-rated but still investment grade Bell-Aliant's 2014 bond now yields 6.7%.

Recession and Default Risk
Recessions are bad times for ordinary people and they are bad for business too. Profits disappear and corporations fail, resulting in some bonds going into default with an investor having to face whole or partial loss of capital. The big question is whether markets have over-reacted and the risk of default has now gone up to the extent prices seem to suggest. Is it likely the Royal Bank or Bank of Montreal will go under, or Bell-Aliant? These companies have continued to pay handsome dividends yet they are legally bound to pay bond interest before dividends. If there isn't enough money down the road, dividends will be cut first.

Though the past is never an absolute guide to the future the table below from a memorandum published on the website of the Canadian Institute of Actuaries and covering periods of past recessions shows that from 1989 to 2007 there has not been a default by a Canadian corporation rated A or higher. .... There's always a first time though.
Corporate Bond Choices
There are several ways to buy bonds. All are available through discount brokerages.

1. Individual bonds - under trading or quotes sections, look for fixed income and narrow the search to corporate; minimum purchase is usually $5000
   
2. ETFs - iShares Cdn Corporate Bond Index Fund (TSX: XCB) with 252 different bonds of varying maturities, all of investment grade; currently yielding 5.7%
3. Mutual Funds - only a few seem to specialize in corporate bonds as most hold a balance of government and corporate bonds; some that do specialize - Bissett Corporate Bond Series A (mostly Canada, some US), Quadrus GWLIM Corporate Bond (holdings with "high level of coupon interest income consistent with reasonable of safety of capital")

Of course, the above is not investment advice from me, it just input for you to consider in making your own decision, as all self-directed investors should do.

Going on Autopilot with Dividend Reinvestment

What do you do with the cash received in your investment account from dividends and distributions from stocks and income trusts? These days the interest paid on cash balances isn't very high. Perhaps you would as a long term investor rather have the money plowed back into the companies you hold already?

A Dividend Reinvestment Plan (DRIP) offers that possibility. Instead of sending you the dividend, the company buys more shares for your account, usually at the prevailing market price, sometimes at a discount (e.g. Bank of Montreal has recently announced that it is offering DRIP shares at 2% discount). Two big pluses - 1) it's automatic after you set it up through your brokerage, a great convenience in time and effort saved, especially with multiple holdings and, 2) it's free - you pay no brokerage commissions.

Broker Offerings
Brokers differ quite a bit in what they offer:

• purchase only whole shares at a time (in which case you end with small amounts of residual cash) or even fractions of shares
• enrol stock by stock for DRIP or for the whole account
• number of stocks which can be DRIP'd (some publish the list like BMO Investorline's here, or you must call the broker to find out)
  

Stingy Investor has compiled an excellent list of Canadian brokerage DRIP offerings (of course, be sure to double check accuracy with the broker).

Some brokers even offer what is known as a "synthetic DRIP" service, whereby the broker will purchase for free extra shares with the dividends even though the companies don't offer it themselves. This can extend an investor's DRIP capability to things such as ETFs, as described by CanadianFinancialDIY in this post.

Canadian shares and trust units with DRIP programs
Stingy Investor publishes here a list, as does blogger Canadian Dividend Reinvestment Plans here. Note that the lists are not identical, no doubt because of timing and thoroughness of updates, so again, check with your broker on a particular company.

US Shares
There are apparently over 1300 securities in the United States with DRIP programs - see the Directinvesting.com search page. Once again, Canadian brokers differ in what they offer regarding DRIPs for US holdings.

How to Set Up the DRIP
Simply phone up your broker and go through the accounts and shares you want on DRIP.

Resources
Stingy Investor's Intro
Robert Gibb's DRIPs 101: DRIP Classifications on the
DRIP Investing Resource Center - Articles, Forum, Tools, Recommended Books, Links
Financial Webring discussion thread on DRIPs/SIPs/Synthetic DRIPs

Normally, a drip is cause for a headache at home, as leaking taps and pipes cause damage and annoyance. Not so with the uppercase acronym DRIP, whose slow and persistent operation can build the wealth in a portfolio while saving effort and cost.

Psychology of Stock Market Investing: Patience

"We have met the enemy and he is us."

Walt Kelly in the Pogo comic strip

As has oft been noted, psychology is the greatest barrier to successful investing as we do things that cause us to under-perform - and by a lot, not just a bit.

The research firm Dalbar found in the study Market-Chasing Mutual Fund Investors Earn Less Than Inflation that US investors in equity mutual funds managed a measly 2.57% annual compound return compared to inflation of 3.14% and the 12.22% that the S & P 500 index earned annually for the 19 years from 1984 to 2003. The reason for the poor result - attempts to chase market performance by hopping from one hot fund manager to another but always one step behind. In other words, investors lacked patience. The problem doesn't just apply to mutual funds but to stocks as well, as investors buy hot stocks after a rise or a friend has whispered a hot tip or a TV show analyst mentions that he likes the company, only to be disappointed and sell at a subsequent decline.

Eric Sprott, one of the most successful Canadian investors and money managers ever with annualized returns of almost 25% since 1982, has found that even with his remarkable record, investors in his fund have become impatient and withdrawn money in the rare down years of his fund (cited in Bob Thompson's new book Stock Market Superstars). He says, "... a short time period is not a very good measuring stick. Really, the longer term is a better measuring stick." Another Superstar, Wayne Deans, says "I think the single biggest weakness with most investors is that their time horizon is way too short." What Sprott and Deans mean by longer term is years. They talk about the patience to wait perhaps several years after they have made an investment in a stock they feel is under-valued in order for the market to catch up and for the price to go up. They also mention how they have had to learn to not sell too soon after the stock price of such a company has at last begun to rise.

It should of course be a moot point that if you need to spend the invested money sooner and cannot wait a few years, then the stock market is not the place to invest.

Antidotes to impatience:

• look at statements less often, perhaps only once a year if your time horizon is many years, or if you are invested in a fund with a professional manager, be it passive indexing or actively-managed; after all, that's why you pay them - to manage your investment
• graph prices or values with a five-year or greater time axis to keep rises and falls in proper perspective, especially important nowadays after major market declines
  
• write down the reasons for buying then when you feel the urge to act, review them to see if they still hold before doing anything; the initial recording will force you be a more systematic and rational at the buy stage and the review at the sell, instead of giving in to impulse. Impatient investors forget that the outstanding investors only act quickly and decisively after doing considerable research to know what they are buying, thus developing an idea of buy and sell value.

Behaving patiently is not easy, as even the Superstars attest. Bob Thompson summarizes - "Many of the managers interviewed, from value to to growth to hedge, said that they wish they were more patient, and it was something they were always working on."

Income Trusts: a Neglected Opportunity?

Income trust investors have had a bad time in recent years. First came the 17% downward price hit from the federal government's announcement Oct.31, 2006 that henceforth such trusts, except for qualifying REITs, would be taxed like corporations. Then came the credit crunch market collapse of 2008, which has seen their price fall significantly more than the rest of the market - in the graph below compare the TSX Income Trust Index (red line) and an ETF (green line, symbol XTR) of income trusts to the TSX Composite (blue line).

The downtrodden and unpopular can provide investing opportunity! There are some enticing indicators of substantial reward too. But first ...

What are Income Trusts?
Key Features:

• a form of equity security - distributions are not guaranteed like debt, hence riskier
  
• frequent (often monthly) and substantial cash distributions - used by investors for regular income
• traded on a stock exchange but are called units not shares and are distinguishable by the addition of the suffix UN to the symbol, e.g. BA.UN.
  
• unlike investment trusts and mutual funds which own baskets of assets or shares in many companies, income trusts are confined to a single company.
• wide variety of business types and thus differing stability or risk

Shakespeare's Primer on Trusts and the Wikipedia article on Income Trusts provide more detail.

Why the attraction now?
HIGH YIELD! At current low prices, the annual cash payout is well over 10% for many income trusts. See this handy extract table from Investcom.com:
That's not the end of the story, however, since cash distributions can and might be suspended or reduced, unwelcome though that might be.

What are the risks to distributions?

1. Payouts too high to sustain the business' underlying needs to service debt and make capital expenditure re-investments. Income trusts may pay out 50-90% of profits on an on-going basis; when it is over 100%, watch out, that will deplete the business if more than temporary or short-term.
2. Leverage - if the underlying business has a lot of debt relative to revenue, downturns can be fatal.
3. Rising interest rates - can damage two ways: a) the underlying business runs into debt servicing problems and b) the fund units lose value since the distribution is less competitive with other sources of regular income like bonds; though the distribution may not decline, its value is less.
   
4. Falling commodity prices - for funds based on resource stocks, whether oil, gas, minerals or other commodities, the effect on unit prices can be rapid and dramatic as sustained drops will reduce the ability to pay distributions
5. 2011 and Corporate Tax - expect a one-time hit to distributions of most Income Trusts when the rule kicks in
   

What to consider in assessing Income Trusts

• sustainability of distributions - use DBRS Issuer Ratings and Standard & Poors who rate many (though not all) funds for stability of payouts; think how much the distribution could drop before the return would be too harmful; some businesses grow their distributions, they are not just stagnant "cash cows" though most of the expected return will be distributions, not gains on the unit price; sustainability risk is generally ranked like this:
  

1. Lowest risk - Power Generation
   
2. Low - Pipeline, Telephone
   
3. Medium - Real Estate: office, commercial, mortgage, apartment, hotel
4. High - Business - retailing, restaurants, trucking, cold storage etc
5. Highest - Oil & Gas Royalty, Commodity
   

• tax character of income distributed - this varies with each fund - some provide mostly dividends, others primarily interest / other income, others a mix of capital gains with dividends; this affects where the fund goes best, in a registered or taxable account

Where to find Income Trusts

• GlobeInvestor Stock filter - use the "Security" drop down menu to select Income Trusts (units); discount brokers probably have a similar feature - I know BMO Investorline offers its clients the Gold version of GlobeInvestor
• Investcom.com - doesn't list them all, but groups them by industry and shows their yield
• PricewaterhouseCoopers Planning for 2011 and Beyond covers business, strategic, tax issues as of May 2008
  
• TMX Money downloadable listing of all TSX-traded Trusts with size and business sector
• CanadianMoneySense Ranking of Top 100 Income Trusts - June 2008 data with online sorting
  
• iShares Income Trust Sector Fund (XTR) and REIT Sector Index Fund (XRE)
• Closed-end Funds at GlobeInvestor - some of them hold income trusts and are themselves structured as trusts; check the ".UN" in symbols then drill down to verify the contents

Disclaimer
Note that this post is not meant to be an investment recommendation. It is merely to illustrate current conditions.

ETFs and Mutual Funds - Calculating Capital Gains

The previous post on this blog explained that an investor must calculate the capital gain when he/she sells a mutual fund or ETF and must report that gain on his/her annual tax return. This post now explains how to figure out the capital gain.

Step 1: The first number to calculate the gain is the amount you receive, quite straightforwardly the net cash after deduction of fees and commissions incurred by the sale.

Step 2: The second number is the cost, or the Adjusted Cost Base (ACB) in tax parlance. The formula is:

ACB =

Total Paid to Purchase Shares/Units (plus fees and commissions)
+
Reinvested Distributions (all of Capital Gains, Income and Dividends)
-
Return of Capital (ROC)
-
ACB of Previous Sales of Shares/Units

The ACB changes with each purchase, distribution and ROC over the years the fund is owned. The ACB is a running total for the fund. There is no selling oldest or newest shares first, they are all mixed together.

Mutual fund companies generally keep track of the ACB and you can see this on statements or obtain this information from them but they also advise to do the calculation yourself since most disclaim liability for possible inaccuracy due to situations such as deemed dispositions and incomplete return of capital deductions.

The ETF companies cannot provide the ACB of your holdings (iShares explains why in this FAQ); you must do the calculation yourself for ETFs using the data on the T3 slips and brokerage detail statements for the T3 (box 21 = capital gains; box 42 = ROC).

It is important to track ACB because if you do not, you will be paying taxes twice on reinvested distributions - once when reporting the gain on the T3 and again when you sell part or all of the holding. Remember, the higher the ACB, the less the capital gain and the less tax there is to pay.

The chart below shows examples of ACB tracking calculations for a mutual fund and for an ETF. Note especially (see yellow cell) that when an ETF reinvests capital gains distributions, no additional shares are issued or created, as explained in the iShares FAQ linked above.


The easiest way to keep track of ACB is to do an annual update when the fund companies announce their tax distributions and issue T3 slips for the previous year, sometime around the end of February. The websites of ETF and Mutual Fund companies disclose the annual distributions on a per share/unit basis, which enables the re-construction of past years if statements or T3 slips have been mislaid.

Additional Info:
Managing Taxes from iShares Canada
ETF Tax Information page at Claymore Canada

Disclaimer: this post is not to be construed as advice; it is for information purposes only. Consult a tax accountant or financial professional for proper advice.

The Mystery of Fund Capital Gains in 2008 Explained

Investors who own ETFs and mutual funds in taxable accounts (i.e. this does not apply to tax-protected accounts such as RRSPs) may be surprised and puzzled this year to receive T3 tax slips that show capital gains to be reported on their income tax return. After all, in 2008 stock markets had one of the worst years in living memory with the TSX down 35%. How could there be any gains one might ask?

Taxable Capital Gains When the Fund Sells: Investor Sees no Cash
Capital gains (or losses) arise when the fund sells one of its holdings and makes a profit during the year; the investor has not sold anything, the fund has. The net of all the sales during the year is calculated by the fund and the capital gains are attributed to the investor for purposes of tax reporting. Such gains are not usually paid out in cash to the investor; instead they get reinvested within the fund through new purchases.

The TSX had reached a peak in mid-June 2008, so stocks sold within a Canadian equity fund up to that point could well have made a capital gain and if few stocks were sold at a loss during the subsequent downturn before the end of the year, the fund might be reporting a net capital gain for 2008. That does turn out to be the case for instance, with the popular iShares Canadian Large Cap 60 Index ETF (symbol XIU). A press release of Dec.24th says XIU has generated a reinvested distribution of $0.14652 per share, which investors will soon see in box 21 on a T3 slip from their broker to be included on their tax return.

Taxable Capital Gains When the Investor Buys(!)
An investor who buys a fund late in the year just before the year-end capital gains distribution can end up paying tax for gains made much earlier in the year. Funds use the list of owners as of a certain date (termed the record date) to parcel out the year's gains, most often December 30th. The T3 the investor receives tells the tale. It may be better to defer the purchase till the new year. Fund companies normally publish year-end distribution estimates in advance of the record date so that investors can avoid the nasty tax surprise if a big capital gain is in the offing.

Taxable Capital Gains When the Investor Sells: Investor Sees Cash
A separate taxable capital gain (hopefully! or perhaps a loss) occurs when the investor sells all or part of a holding in a fund and the proceeds exceed the net purchase cost. The investor will NOT receive any T3 tax slips from the fund company to use on his/her tax return. It is up to the investor to calculate and report the gain.

Additional Info:
ETFs - iShares Canada Distribution History links for each fund - e.g. for XIU
Claymore Canada Tax Information Guide for 2007 (2008 tba) covering all its funds

Mutual Funds - follow links to fund companies at FundLibrary.com and look for Tax or Distribution info at each company's site; a typical handy guide is Mackenzie's Mutual Fund Tax Guide

As always, this post is not to be taken as advice. If you are unsure how to handle distributions, contact an accountant or other financial professional.