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Posts from the ‘Investments’ Category

Dec 11

Taking Note of the Possibilities: Auto-Callable Contingent Income Notes

I have a confession to make – I’m fussy about surprises.  I’d much rather save them for birthdays and major holidays than when reviewing my investments. Admittedly, volatility can sometimes be an investor’s best friend, such as when that a penny stock is suddenly worth dollars, these happy surprises are outweighed by the times things go the other way, which leaves me feeling like I’ve just found out that Christmas was cancelled while sitting on a piece of birthday cake. And, for investors who are on track for a comfortable retirement, are tired of getting motion sickness when tracking the ups and downs of their stock portfolio or are already in retirement and can’t afford to get it wrong, you should feel the same way.

I’ve previously written about how volatility when you have your good vs. bad investment years (your “sequence of returns”) can have a profound effect on the eventual size of your portfolio, particularly during retirement when you might have to “sell low” to pay for golf and groceries. On the other hand, I’ve not written nearly enough about some of the other risks investors have when saving for retirement, such as running out of money due to not taking enough investment risk: GIC investors, this might mean you! If your money needs to last you through 30 plus years of retirement, settling for investment returns that might not even keep up with inflation after including taxes potentially means tough times if you live into your 90’s (or 100’s if some of those alleged medical advances actually pay out) unless you’ve got other assets that pick up the slack or have either have or will later inherit a healthy nest egg.

Structured Notes – What Are They?

Although I love the regular income that GICs can produce and appreciate the peace of mind that comes with the typically complete capital protection, I’m willing to take a bit more risk to hopefully reap a lot more reward. Although there is no silver bullet perfect for every occasion and every market, I’ve found a few tools that can produce a significantly higher income without dramatically increasing the risk of getting birthday cake on my snazzy new pants.  In other words, while I’m taking on more investment risk than a GIC, I’m also giving my portfolio a chance to at least keep up with inflation to combat longevity risk, — otherwise known as the possibility of having to survive entirely on bologna sandwiches later in life. Today’s offering talks about one of these tools designed to thread the needle between investments that are too unpredictable and those that too stingy: auto-callable contingent income notes, a subclass of a class of investments known as structured notes.

In general, structured notes are investment products created by banks that track the performance of underlying investments and pay investors according to how that particular underlying basket of investments performs.  The banks issue a bunch of different notes with different potential returns based on different underlying investments, ranging from the performance of the entire TSX, a basket of a few stocks, such as the big 5 banks, or even the performance of a single stock, such as Tesla.

In many ways, structured notes are like betting on sports, although with typically far less risk than overzealous Leaf fans may have experienced over the years.  The banks offer an ever-changing array of notes, each with different potential outcomes and levels of risk, depending on current market conditions. Investors investigate the different notes and place their bets based on their assessment of risk and return. Like any good bookie, the banks cover their risk by purchasing options or zero-coupon bonds in the investment market that match the terms of the notes on offer so they are not out of pocket if the investors win.  In fact, both the banks and the investors have something to celebrate if this happens– since someone else will ultimately be financing the investors’ profits, the bankers are still smiling because they got to use the investors’ money along the way, minus the cost purchasing the protection, to do bank-like things, like lending it to other clients or investing it for their own profit.

Although there are a wide variety of notes on the market, I just want to talk about one type– auto-callable contingent income notes, a name obviously not chosen by an advertising professional. This product provides a regular income stream provided that the underlying investments doesn’t drop below a predetermined limit.  It is typically considered a hybrid of both stocks and bonds – the returns are based on the performance of stock, but investors don’t participate in the growth of the underlying investments (although there are other structured notes that offer this feature if you’re so inclined.) Instead, investors get a constant payout for each specified period (such as monthly, quarterly or annually), much like a bond unless the underlying investment has dropped more than a preset amount as of a specific day.  Also, unlike stocks, any proceeds from notes are almost always taxed as interest.

The Value Proposition and an Example

The best way of truly describing this class of notes is by way of example. Although I’ll recklessly throw some investment jargon your way, keep reading and hopefully all will soon become clear.  A typical note issued in today’s high interest and uncertain times might offer 12% annual income paid monthly (each payment is called a “coupon”) based on the underlying performance of a basket of Canadian banks with a 30% barrier and a 30% partial maturity guarantee when the note matures in 7 years (although 5- and 3-year maximum lifespans are also common) with a 110% autocall feature. Translating into English, this means that so long as your basket of bank stocks hasn’t declined in value more than 30% from the date the note was issued on a preset  day each month, you earn that month’s interest coupon. If, instead, financial Armageddon hits and your basket of banks is down 35% on the day in question, you miss that month’s payment. The next month, however, if the banks have rebounded even slightly to 71% of their original price, you earn that month’s income, although last month’s lost interest remains lost and gone forever most of the time.

This monthly calculation continues until one of 2 things happen – either the underlying basket appreciates by more than 10% of its original value (the “autocall” price) or 7 years have passed and the note “matures.” In the first scenario, investors get their final interest payment, plus all of their original investment back as of the month the basket hits its target growth rate. In the second situation, it all depends on the value of the basket at the time of maturity, plus the amount and type of downside protection purchased. In the example I’ve given, which is a 30% “barrier,” at maturity, if the basket is worth at least 71% of the original value at that time, then the investor gets a full refund of the original purchase price and their final interest payment. On the other hand, if the investment is only 69% of the original value, then they would only receive $69 of the original note. Put another way, this investor gets all their money back so long as the underlying bank bundle hasn’t declined by more than 30%, but, if it has, they are on the hook for the entire loss.

If the latter outcome is too risky for your blood, you might purchase a note with a “buffer” instead.  While a barrier provides protection if the loss is within a certain range, buffer notes offer protection even if the loss exceeds the preset threshold. Using my previous example, if you owned a 30% buffer instead of a 30% barrier and the basket was worth $69 at maturity, you’d still get back almost all of your original investment, although your monthly interest payments would likely have been less than those offered through a barrier note. As you’d expect, you pay for this extra protection by accepting a lower yield since the bank has to buy more expensive protection to cover the potential loss.

Other ways to Protect Yourself

Although buying a buffer dramatically reduces downside risk, that is not the only way of increasing your odds of a positive outcome. Here are some other tactics to increase the chances of a happy ending:

  • Increasing the size of the buffer or barrier. Is 30% not enough protection to protect the quality of your nightly slumber? Consider buying 40% downside protection instead, both to protect your regular income and how much you’ll get back if the note isn’t redeemed until maturity.
  • Purchase notes with a memory feature. Although being under water on the observation date typically means losing that period’s payment forever, notes with a memory feature allow you to play catchup. Once the note is once more above its barrier or buffer on a future observation date, the investor gets both their regular payment plus any payments they may have missed in the past.
  • Buy notes that go low. There are occasionally notes that calculate the initial value of the note for future observation date purposes based on lowest value of the underlying bundle within the first observation period. For example, a note with a semi-annual coupon based on the TSX with a 30% barrier with this additional feature would pay that half-year’s coupon so long as the value on each observation date was at least 70% of the value of the TSX at its low point during the first 6 months after the note was issued rather than the bundle’s original value at the time the note was issued.
  • Opt for monthly coupons. If there is a precipitous decline in the value of the underlying investment on an observation date, it’s far better if you only miss one month’s coupon payment instead of perhaps an entire year’s worth. Different notes offer different payout periods, such as monthly, quarterly, semi-annually or yearly. Since a really bad day in the market on the observation date means not getting paid, picking the monthly coupon option means only missing one month’s worth of income if the investment world is far less dire a month later. Although picking shorter payment periods can cost you the occasional payment if the bundle is underwater for a month or two but rights itself by the end of the quarter or year, I’d much rather accept this risk than chance risking an entire year’s worth of income by selecting a note with longer gaps between payments.
  • Picking a boring bundle. Hedge your bets by picking a note based on an underlying investment you think is conservative or which you view as already significantly discounted. As an added bonus, because of this recent volatility, notes based on investments with a recent decline generally offer higher coupon payments. Some clients recently purchased notes based on Canadian banks for these reasons, for example. It is even possible to purchase a note based on an entire index like the TSX rather than a specific sector to if you feel that this is a safer bet.
  • Pushing out the lifespan of the note. The duration of the structured notes can also vary. One school of thought suggests that the further out in time before a note matures, the smaller the chance that the underlying basket will be less than the protection purchased at that time. If you believe that the market ultimately wins in the end, increasing the distance between purchase and the maturity date plays into this philosophy. Moreover, since notes can also be sold on the secondary market, notes with a longer maturity period aren’t as volatile if you need / want to cut bait and sell along the way.
  • Selecting the autocall carefully. Most notes do not make it to maturity. In fact, the majority are redeemed within a couple years of issue. Sometimes this is a good thing and sometimes, not so much. If you love the interest rate and the underlying basket, look for a higher autocall threshold such as 110% of the original bundle value vs. 105% so you can keep raking in the cash for a bit longer. On the other hand, perhaps you just want to park your money in a note until you feel better about the market and / or don’t love current note rates.  If you have an autocall feature where you’re redeemed when the investment climbs by only 5% vs. 10%, you will  be bought out potentially far sooner if the investment performs, at which time you can redeploy your capital into either another type of investment or perhaps another note with more favourable terms.
  • Purchase a note with the right initial observation date. Even if you have a monthly autocall feature, your note will have a minimum initial waiting period before the autocall feature kicks in. If you love your current note, picking perhaps a 1-year initial observation date vs. 6 months may help keep the good times rolling that much longer.
  • Buy a bundle of bundles. Rather than just purchasing a single note based on a single bundle, spread out your risk by purchasing several different notes based on different underlying investments. In fact, structured note ETFs have recently come onto the market in Canada. Although the one I investigated is too new and has only 20% barrier protection, who knows what will be on offer in a couple years or how existing products have performed.
  • Pick a note that matches your ultimate time horizon. Although most autocall notes are redeemed within a couple of years and there is a secondary market should you wish to sell, consider matching the ultimate duration of your notes to when you need the money. For example, if investing in a TFSA to purchase a home in 5 years, a note with a 7-year maturity period might not be the one for you. As stated earlier, however, if you really need the cash, there is a way out. In fact, structured notes may be cheaper to unload in some situations than non-cashable GICs, depending on how your note is priced in the secondary market.
  • Don’t be a one trick pony. No matter how much you like this type of investment, continue to diversify your portfolio with different types of investments. For GIC fans, this might mean combining structured notes with a few GICs as well in order to further reduce your risk. Ditto for those investors who are big on bonds, preferred shares or perhaps other investments like Mortgage Investment Funds, which I see as the main competitors, although each has their own pros and cons.

More Note Planning Tips

In no particular order, here are some more tips to consider when looking into purchasing notes:

  • Shop around. Not all banks offer the same rates at the same time. If your broker is linked with one of the big banks, make sure that (s)he also looks at what the competitors are selling.
  • Realize that notes pay interest and plan accordingly. Although notes are based on an underlying bundle of stocks, all distributions are taxed as interest income. Accordingly, they are best owned in registered plans, family trusts with low-income beneficiaries or by low-income individuals not worried about things like the GIS clawback.
  • Focus on the big picture when assessing risk. When choosing between this type of product vs. alternatives like GICs, preferred shares and bonds, consider the risk of a note being redeemed for less than full value at maturity but also the extra income you may have received along the way vs. some of these alternatives.   It could be that the extra cash received before then from a higher yield, particularly if you have buffer protection that absorbs most of the loss, still leaves you better off than something like a GIC with 100% principal protection but a much lower yield. Do a similar analysis if deciding how to allocate money among investments like notes, bonds and preferred shares, although you’ll also have to factor in the chance of those other options producing capital gains or losses (although this could also arise if trading structured notes on the secondary market.)
  • Get your broker to custom-fit a note. Like a good bookie, banks are typically willing to create tailor-made notes for the right client if worth their while ($1 million seems to be the minimum note size.) Accordingly, if you can’t find the exact note of your dreams, see if your broker or portfolio manager is willing to work with a bank to create a custom fit. It’s not like you’d have to purchase the whole thing – my own portfolio manager is currently working to create one that a bunch of his clients will share, plus whatever other investors may snap up.

Performance Notes

The following stats, plus many useful tweaks and suggestions, were provided to me by two Portfolio Manager friends at Aligned Capital – Thomas Tsiaras and Wail Wong. A big thank you to both of them for their expert advice.

The following chart pertains to National Bank products from 2016-2022. Our notes of choice, auto-callable contingent income notes, are included as part of the “Non-Principal Protected Notes” family, as opposed to the “Principal Protected Notes.”  The first category covers notes that include only partial protection (an average of 32.7% downside coverage) while the second cluster fully guarantees that investors will not lose money.

While the fully protected notes, including market-linked GICs (which are not be confused with your guardian variety fixed income GICs) did ensure that no one lost money, they only produced an average annual return of 3.3%. In contrast, notes with partial protection averaged an annual return of 8% even after factoring in losses.  Moreover, the partially protected notes failed to make a profit only 2% of the time, versus 24% for notes with full coverage. In other words, in exchange for taking on this extra risk, which only resulted in neutral or negative outcomes 2% of the time, the investors earned more than twice as much than their more conservative friends, with a higher chance of making money.

Diagram Description automatically generated

Fee Classes

Notes are either sold as “A” or “F” class, just like many other types of investments, either with an embedded commission for the advisor (A Class) or with that commission stripped out, with advisors charging their clients an advisory fee directly (F Class.) As you would expect, F class notes offer a higher yield.

Some advisors may offer clients the choice of purchasing either class of notes – those with a one-time fee embedded into the product but with a yield that is adjusted to cover these costs or those with the commission stripped out but with ongoing advisory fees paid directly, although this will likely require clients who purchase both versions from the same advisor to hold them in different accounts, one managed by the advisor and the other self-directed. In some cases, choosing the Class A notes can even be a win-win for both client and advisor – the lower A class yield may be less than what the advisor charges management fees, but the advisor still makes a healthy one-time commission, particularly if the note is sold or autocalled within a couple years and the clients reinvest the proceeds with that advisor.

Conclusion

Although they have been around for a while, auto-callable contingent income notes are currently one of the trendiest investment options for clients looking for higher yield with some extra protection. Although they may have more moving parts than a caper movie, don’t let that scare you off from putting in the work to see if they have a place in your own investment portfolio. The retirement you save might just be your own.

Apr 13

Playing With House Money #2 – Gifting, Loaning or Co-owning?

In my last article, I discussed many of the different ways that Canadians hankering to eventually own their own home could best save towards funding this dream. Today’s offering discusses the three most common options available for parents when the youngster wants to buy a home but needs a little more help to get them across the finish line when it’s time to purchase:

  • Gifting;
  • Loaning; and
  • Co-owning.

And, although the article discusses parents helping children, I’ve only done this to make this article easier to write- the options discussed apply to anyone looking to help a family member or even a really, really, really good friend get a place to call their own.

Overview

Before going advancing any money, I strongly suggest first taking a step back and having a heart-to-heart conversation with yourself. Some of the questions you may pose are:

  • How will helping impact your own financial future? How much could you safely loan or gift without risking a future full of Kraft Dinner during your so-called Golden Years?
  • Are junior’s financial forecasts realistic ones? And, are you prepared and able to commit more money in the future if (s)he has bitten off more than (s)he can financially chew? In some cases, you all may ultimately be better off if junior scales down their dreams so that (s)he can have both a comfortable home and a comfortable lifestyle.
  • How secure is the child’s relationship? Not only will this affect whether or not now is the time to advance some funds, but the form this assistance might take.
  • Is struggle good for the soul? And, is it possible to be too generous? Will this particular child benefit from having to save a little longer, scale down expectations or struggle with the responsibility of living on a tight budget? Or, does this parsimonious approach merely make life needless harder while simultaneously depriving you of the benefit of watching the next generation enjoy the fruits of your generosity? Feel free to insert any additional existential questions of your own.

Meet Your Options

Should you still wish to help after wading through this swamp of difficult questions, the next issue is what form of assistance is best. Here are the leading contenders:

  1. Gifting – Simple but Risky

Assuming that you will never need the money back, this option is the simplest and often works out just fine. All the same, allow me to don my legal robes and point out some of the things that can go wrong, sprinkled with a few suggestions about how to limit your risk:

  • If your child is successfully sued, your gift is up for grabs.
  • If junior is financially irresponsible or faces problems like gambling addiction, you don’t have the same financial clout as someone who is a lender or co-owner.
  • There is no guarantee you’ll ever get the money back if you later discover that your child is married to Bernie Madoff’s evil(er) twin. It is often better to give (or loan) a little less than to risk running short of cash yourself when a super senior. You can always give more later once your own financial future is more certain or when your kid demonstrates that they are not a complete financial train wreck.
  • Although most provinces protect the amount of a gift in the event your child divorces, (s)he will still have to divide any growth in the place’s value 50/50. And, in provinces like Ontario, gifts used to purchase the family home are ignored when divvying up the matrimonial pie. In other words, if a marriage based in Barrie doesn’t work out, half of your generosity will end up in the hands of someone your child may now cross the street to avoid. Is this a risk worth taking?
  • If your child dies first,  you have no control what happens to your gift. While most parents wouldn’t mind so much if the gift passed to their grandchildren, you might feel decidedly differently about a $200,000 gift passing to a son/daughter-in-law you can’t stand or some  random charity a single child might name in their Will, particularly if you have other children that you’re rather received the funds.
  • If planning to gift to other children in the future, do you need to include language in your Will to equalize things at that time if you don’t get the chance to do so during your lifetime?

If gifting still sounds like the best option, I suggest actually going the extra mile and documenting your generosity in writing in order to avoid potential legal problems later. If your intentions are unclear, the law assumes that any funds paid to adult children are loans, rather than gifts. Accordingly, if your kids don’t get along, or your new wife isn’t the biggest fan of your old kids, your gift to those children may be unintentionally clawed back when you’re 6 feet under. Lawyers prepare something called “a deed of gift” that puts this issue to bed. Not only can these documents ensure that your child gets to keep the gift, they can also hopefully avoid hard feelings over Christmas dinners after your ashes have been scattered over your favourite golf course if other family members had a different understanding of your intentions even if they don’t involve lawyers.

And, if you are planning to help other children in the future, consider whether you want those children you didn’t get a chance to help during your lifetime get a bigger share of your estate later. If the answer is yes, also consider whether you need to bump up the value of any post-death equalization payments in your Will to take into account things like inflation and what planners calls the “time value of money.” Put another way, a gift of $100,000 5 years ago is worth a lot more than a similar gift made today – do you need to adjust any equalization payments to take this into account?

  • Loans – Help with Strings Attached

9 out 10 lawyers prefer lending over gifting 95.2% of the time when the size of any cash advance is at least 6 digits long. It’s not always because of the things we can anticipate going wrong, but because of the things we don’t. Knowing that we can’t predict everything that might go awry, we like to keep our options open just in case.  Unlike gifts, loans can be called in if parents do need the money back, the child gets sued, has a failed marriage, likes to bet on the ponies a little too much or (insert reason of your own.) It’s not like you need to charge interest and it’s always possible to forgive the loan at a later date, such as in your Will – it’s simply about adding a little extra protection and flexibility to our clients’ planning.

If you’re pretty sure you might need the money back or are actually having to borrow yourself to help the child get that housing toehold, a loan becomes an even better idea. In such cases, perhaps you do charge the child interest equal to your own borrowing costs, such as if you’re using your own HELOC to come up with enough money to get the child into a bungalow. I’ve even heard of some parents taking out a reverse mortgage to help the child get started, although I worry about what happens if mom and dad ever need to go into assisted living and most of the equity in their place has essentially been transferred into junior’s abode.

If going the loan route, here are few options, recommendations and consideration to chew on:

  • Review the law regarding division of property in the event of a divorce. Many provinces protect the sum originally gifted to a child if (s)he divorces, even if any increase in the home’s value is still split 50/50. On the other hand, this is not a universal law and if you live in Ontario, any gift funneled into the family home is unprotected. Accordingly, since loans remain enforceable, gifting rather than loaning can be an expensive mistake if your daughter’s marriage later unravels at the seams and she happens to live in Barrie, as mentioned earlier. (To be clear, I actually quite like Barrie, just not Ontario’s spin on how the house is divided upon divorce.)
  • Document the gift in writing, preferably in front of an independent witness, so you can prove both that it was a loan and its terms. On the latter point, if you are looking to charge interest or have a repayment schedule, documenting the intentions in writing may avoid some misunderstandings and awkward conversations down the road.
  • If charging interest, consider a variable rate loan pegged to a benchmark, or, if you really, really like fixed-rate mortgages, include rate reset provisions further out in time, such as every 5 years, as well as a formula, such as pegging rates to bank rates at that time for a similar mortgage. Although you may not always pass along any rate increases, it’s a lot easier to waive or modify terms in the future if you’re feeling generous than to ask for a rate increase out of the blue later in life when you’re charging 5% less than current mortgage rates or what you’d hope to get if investing the loan money elsewhere.
  • If really worried about protecting the loan, such as if your child is not exactly a financial superstar or they might sued at some point in the future, consider registering the loan against the property like banks do when providing mortgages. On a practical level, if the child also has a bank loan, this may present problems or you may need to grant the bank the right to get paid first if there is ever a forced sale, but this option is at least worth investigating if you start to hear about your child missing credit card payments.
  • Consider requiring your children to sign a prenuptial as a condition of a loan if his or her spouse or their family aren’t contributing as much towards any home purchase or your child goes into the relationship with a lot more wealth, particularly if (s)he already has children from a previous relationship. This might be the pretext your child was looking for but was too love-struck to bring up in casual conversation. You playing bad cop, albeit one with a large cheque book, may ultimately save your child a lot more than the value of any loan should their relationship go south. Moreover, prenups and cohabitation agreements also cover off Will challenges. Although your child may not live to see the benefits of the prenup, his or her children may be the ultimate winners when the stepfather or stepmother of your grandchildren is prevented from claiming more of the estate at your child’s death than your child had wished and bargained.
  • Make the loan to both your child and their partner so that you can potentially collect from either of them. This provides you with more protection and flexibility. For example, on your child’s death, it is easier to collect from the spouse or at least protect the value of the loan if the spouse enters into a new relationship. Some parents may still forgive the loan at their own death, but others like the idea of gifting the remaining loan balance to their grandchildren in trust in order to ensure that they get at least that much of the house one day.
  • If you do need the money back one day, be clear on a timeline, such as an event like retirement, your 65th birthday or when the child renews the bank mortgage in 5 years. Not only does this help with setting expectations, but it also allows your child to budget for this eventuality when managing their own finances, which vastly increases the chance that (s)he actually has the resources to make this happen when the target date arrives.
  • Talk about the loan in your Will. If you plan on forgiving it, say so. If you want it deducted from a child’s share of your estate instead, say that as well. If nothing is said, it will be treated as a loan to be repaid most of the time, but why leave it to chance? Even if that is your intention, any uncertainty can lead to bad feelings among the rest of the family if they don’t agree on what you really wanted to happen. And, if you want the loan transferred to someone else, like a grandchild, say that as well.
  • As mentioned earlier when discussing gifts, if you haven’t loaned to your other children at the time of your death and have interest-free loans to others, do any equalization payments to the have-not kids need to be bumped up beyond the mere value of the loan to level the playing field?  Consider charging notional interest (but don’t make the calculations too complicated) to increase the amount of any equalization payment. For example, I have had some clients add amounts like 5% per year to the value of any previous loans when determining how much the loan-free children should get before the rest of the estate is divided.

Going on Title – Helping But Not Necessarily Giving

There are several different scenarios where mom and dad might actually end up on title to a child’s house. I won’t pretend to cover all of them, but I’ll point out a few scenarios where this might either be required by the bank or something you might want to do for other reasons.

The most common situation is when the child can’t qualify for mortgage on their own and the bank won’t give them the cash unless you’re both on title and are also responsible for ensuring that the bank gets their biweekly pound of flesh. Although it is theoretically possible for you to stay off title but only guarantee the mortgage, I haven’t seen this actually happen, unfortunately. Typically, the parents required to be on title take a 1% interest (although you may want a bigger stake as I’ll discuss later), which is the minimum amount necessary to appease the bankers. If this is unavoidable, so be it, but lawyers really do hate it when clients end up guaranteeing someone else’s loans, which is what you’ll be doing when signing onto the mortgage. It’s one thing to write a child a cheque for a set amount and knowing that is all you might lose, but something completely different to know that you might be called on to make someone’s ongoing mortgage payment or perhaps a lot more. Although there will hopefully be enough equity to pay the bank back should this happen, there are no guarantees. Moreover, it is generally a lot better for Christmas dinners in the future when family finances aren’t connected at the hip. Anyway, if guaranteeing or being a copayer of a mortgage is the only way forward and you’re comfortable with the situation, at least proceed with your eyes wide open.

In other cases, perhaps mom and dad want more than just a thin slice of the new place. For example, if they are providing a 30% down, they might want 30% ownership. For parents considering taking on a larger ownership stake, here are some more of the pros, cons and suggestions, using this 30% ownership example:

  • If a child’s relationship fails, you are entitled to at least 30% of the equity rather than just the amount you originally contributed. On the other hand, this may not be as good as it sounds. If the place has declined in value, you might get back less than you invested. Moreover, if you have funded the entire down payment and the rest was mortgaged, your 30% of the equity may actually be less than your original contribution even if the property has gone up in value. For example, if you contribute the entire $300,000 downpayment for a $1,000,000 property and take back a 30% ownership stake, you could potentially still lose money if the property sells the next day for $1,100,000.  Although the total equity has increased to $800,000, unless you have a proper agreement in place that ensures that you get your original contribution back first, you may only be entitled to 30% of $800,000 or $240,000.   Accordingly, a written agreement is a wise insurance policy for any time you’re co-investing with a child, particularly if they have already coupled up or might find that special someone in the future.
  • “Going on title” ensures that the child cannot sell or borrow additional funds against the property without your knowledge, and in most cases, consent. If you merely have a written loan agreement without registering a mortgage against the property, your child can do as they wish. For younger or troubled children, or if you have control  / trust issues, this may not be an acceptable risk.
  • You’ll have more to pass along to grandchildren or others compared to merely calling in a loan or transferring it to grandchildren if your child predeceases you. Although transferring a loan to the grandkids does provide some benefit, the value of any loan will not have increased along the way and the spending power of any loan 15 years down the road is likely a fraction of what the money was worth initially, which means a lot less to pass along to junior’s own children in real dollars. If you have a piece of equity to pass along instead, hopefully the value of your piece of the pie will be a lot more significant.
  • Unless you’re also living in the house with your child, which is something becoming more common, your percentage of the property probably won’t qualify for tax-free growth under the principal residence exemption. While your child’s share of their home will still sell tax-free, your portion of any growth will be taxed as a capital gain. If weighing choices, particularly if you don’t need the money back and plan on gifting it to the child at death, the tax hit that could have been avoided if the child was the only one on title is one of the biggest negatives. Noting the typically high tax rates people face at death, this could mean losing 26.75% of any increase in value to the tax man.
  • If you have to borrow to come up with the money and may be cash-strapped for your own retirement, taking an equity position, along with that written property agreement I am harping on about can be a win / win result. This also assumes that the child can either pay you out (such as by refinancing) or is willing to sell when you need your retirement dollars. It’s also possible to sell in stages to make this more affordable, which might also save you some tax dollars by staggering any capital gains over multiple years rather than having it all taxed in a single year. Ultimately, this strategy is essentially investing with your child rather than with your stockbroker to fund your retirement. The key is ensuring that you’ll be able access your capital when you need it.

When co-owning property with a child, here are some suggestions when looking at a written agreement:

  • Don’t try to do it alone. Get a lawyer involved and ensure that any agreement either says the others got independent legal advice or were advised to do so.
  • Have your child’s spouse be a party to the co-ownership agreement. This offers greater protection if your child dies or divorces. Although you don’t need to enforce every part of the agreement in every situation, why not have that option?
  • Clarify who is responsible for ongoing costs related to the property or how they are to be apportioned. This is particularly important if there is a mortgage or if renovations are likely in the possible.
  • Particularly if you’ve paid most or all of the purchase price and the child is covering all of the mortgage, determine how the equity is to be divided when the time comes. For example, do you get your down payment back and your kid gets any amount paid towards the mortgage back  before the rest of the equity is divided?
  • Include provisions for when you can compel the sale of any property if the kid can’t or won’t buy you out, such as at your retirement or various deaths or any time you want with a set amount of advance warning.
  • Consider adding restrictions on using the home as collateral without approval of the other parties.
  • Require mandatory mediation and binding arbitration instead of court if there is a problem with the agreement. This may be particularly useful if something happens to your child and you have to deal with that unreasonable son or daughter-in-law.
  • Consider if any of the parties want to have life insurance on the others to pay for a buyout on the key person’s death.
  • If you want the child to receive any remaining equity on your death as part of their inheritance, clarify how the place is to be valued, particularly if that child might also be your executor, in order to avoid any conflict-of-interest worries. This might simply mean requiring a professional property appraiser paid for by your estate. Also, specify which costs should be paid by the child receiving the property should pay and which you want covered by your estate.

Final Words

Helping children own their own home can not only be a family affair, but also a shared dream. The goal is to prevent any generosity on your part from turning into a nightmare. Fortunately, there are several ways of protecting against things go wrong. Taking the time to carefully consider your options and to document your intentions can ultimately make all the difference.

Apr 1

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Covid Contemplations: What to Do If You Have Been Socially Distanced by your Finances

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In this eerie time of social distancing, medical mayhem and financial carnage, I feel like a background character in a cheesy made-for-tv movie starring B-grade actors from the 70’s. Unfortunately,  the chaos and risk are all too real, although the consequences and aftermath remain a riddle wrapped inside an enigma.

For those of you, however, who are trying make sense of their financial picture, I do have a few suggestions to lessen the financial pain and some things to keep in mind when you are deciding what to do next.

Consider Future Tax Issues When Making Your Financial Decisions Today

When reading some of the tax-planning options I discuss below, particularly those about harvesting capital losses, it’s also really important to consider how things might look a few years down the road when Covid19 is hopefully a distant and not particularly fond memory, like door-to-door salesmen and (fingers crossed) manbuns. I simply can’t imagine a future that doesn’t include significant tax hikes, particularly for those in the higher tax brackets or for most people in their year of death. I also worry if this might also include increasing the inclusion rate for capital gains from 50% or, for those of you not up on tax-speak, what percentage of any realized capital gains is actually included as taxable income and what part is tax-free. Keep in mind that this was something tax types were stressing about even before this all came down.

In the past, as much as 75% of capital gains were taxed on sale. If the inclusion rate goes to 75% again, this would mean paying 50% more tax on gains than we are right now! For example, if you had a $10,000 capital gain and were in the 40% tax bracket, you’d have to pay $2,000 in tax at the 50% inclusion rate ($10,000 x.50 x.40). If it goes to 75%, then you’re out of pocket $3,000 ($10,000 x .75 x.40). Hopefully, if the inclusion rate is increased, it’s not quite so drastic – I just used 75% as an example since it was a number our government had charged previously. Essentially, just like when setting any other tax rates, they can pick any number they want, limited only by the fact that they want to get re-elected and probably don’t particularly enjoy having their likeness burned in effigy.

A) Capital Gains

For those of you with unrealized capital gains from those bank stocks you bought in the days of disco, there are some planning opportunities available for you, particularly if you expect to be in a lower tax bracket than usual this year anyway.  Here are some of the reasons why you might want to trigger some of those gains now:

  • Your other sources of income are also affected this year and you’ll be in a lower tax bracket than usual. Although paying taxes ahead of schedule is not something I love doing, you might be better biting the bullet now vs. selling in a few years during the new tax reality. It also may also mean not having as much money in the market to capture any future market recovery and receive dividend payments if you have to divert some of your capital to pay the tax bill next year unless you have offsetting capital losses so consider this carefully. On the other hand, it’s not like you need to pay the tax bill today – this is a bill you won’t need to cover until April 2021.
  • You have other stocks that are underwater and would generate capital losses upon sale. You could apply those losses against those gains so you won’t have to pay the tax man this year and can keep all of your capital invested to hopefully participate in any recovery and generate income while you wait.
  • You have losses from previous years already on the books to use up so you won’t actually be triggering a tax bill. Triggering gains at the current inclusion rate, even if you aren’t actually paying any tax on them because of your offsetting losses, will still save you tax in the future if inclusion rates change going forward as I explain later in this article.
  • You are worried and were going to take some money off the table anyway.
  • Your portfolio wasn’t properly diversified, previously, it would have meant paying too much tax to rebalance previously. Now that values might have declined, that tax bill isn’t so high and the tax pain isn’t too great. Although you are selling when markets are down, you will also be purchasing your new investments at a discount. This works even better if you have some of those offsetting losses we also discussed.
  • Your risk tolerance has changed, or you no longer like your current mix of investments anyway.
  • Your capital gains are inside your company and you are really worried about the inclusion rate for gains increasing going forward. If this happens, corporate investors will suffer another hit. Our tax system allows companies to pay out the non-taxable portion of capital gains tax-free to its shareholders (i.e. currently the 50% that isn’t taxed). If the inclusion rate went to, say, 75%, then shareholders would only be able to take out 25% of the gain tax-free, which is half of what they can do now. When coupled with the higher tax rates we’ll likely be paying in general going forward, this might be enough incentive to lock in those tax-free payments now, particularly if the business owner isn’t making as much money from other sources that year anyway. If this might be you, then you might hold off on selling company-owned investments that have losses, as realized losses offset how much of the gains you can withdraw tax-free.
  • You are looking at other uses for your money, such as permanent life insurance, income-splitting it with a spouse or through a family trust, paying down debt or perhaps helping the children out a bit more now than you’d previously anticipated.

As a final point, it is also important to remember that if you do sell a stock that is in a capital gain position but you still love it, there is nothing that stops you from buying it back whenever your heart desires. Although you must wait 30 days after selling a loser before repurchasing it, there is no such rules when reconnecting with a former flame that you previously sold at a profit.

Capital Losses

When deciding whether or not to trigger capital losses, here are some of the things to keep in mind when making decisions:

  • If tax rates and the inclusion rate both increase in the future, triggering capital losses in later years to offset future gains might save you more money over time than triggering them now, particularly if you’re ultimately going to be in a higher tax bracket in the future anyway.

 We talked earlier about how the inclusion rate works for capital gains and how an increase of the inclusion rate from 50% to 75% would mean including $7,500 of every $10,000 capital gain as taxable income rather than just $5,000. The same is true for capital losses – if the inclusion rate was increased from 50% to 75%, this means that you get to deduct $7,500 per $10,000 of bad decisions rather than only $5,000.

It all comes down to when you trigger the losses. Typically, when inclusion rates are increased, those increases don’t apply to losses already on the books. For example, if you trigger a $10,000 gain in a dystopian future reality where inclusion rates are 75% but had an unused $10,000 capital loss on the books from this year, the two would no longer cancel each other out. Because you triggered the loss at a time when the inclusion rate was only 50%, you would only get to deduct $5,000 of that total loss of $10,000 but had to include $7,500 of the $10,000 gain as income, meaning you would still need to pay tax on $2,500. It’s always possible that the government could increase the inclusion rate for past losses if they decide to increase the inclusion rate for new gains. Personally, I think it’s more likely to find discount hand sanitizer  and toilet paper on sale next week than for that to happen.

  • If you want to trigger capital gains this year for some of the reasons discussed above, i.e. you’re going to be temporarily in a lower tax bracket and are okay paying some tax now at current rates, you won’t want to trigger any capital losses this year, as they have to applied against this year’s gains.
  • Triggering losses now will give you more flexible for rebalancing your non-registered portfolios going forward since you can apply these losses against future gains so that you can rebalance without tax consequences until those losses are used up.
  • You have some big capital gains from the last 3 years and want to carry back this year’s losses to get back some of last year’s taxes. You’ll have to wait until you file your 2020 tax return to do this, but it might be worth the wait if you were in a high tax bracket then and don’t expect to be in the same place going forward.
  • You adopt the bird-in-the hand approach and want to deal with today’s taxes and inclusion rates rather than guessing about how things might look in the future. Likewise, you might expect some of your losers to rebound and might want to just lock in the losses now for flexibility’s sake even if this means having more taxable capital gains in the future if your reinvested dollars make money.

As a final thought, it is important to remember that you,  your spouse, your company, etc. must wait 30 days to repurchase any investments you sell in order to be able to realize your capital loss. If you are still really bullish on the investment’s long-term future, then you could look at similar alternatives, at least until the 30 days have expired, unless you’re happy to sit on the sidelines for the short term.

Find Some Balance

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Somewhat ironically, some of my client’s biggest financial planning headaches a few weeks ago was not being able to rebalance their portfolios without triggering big tax bills. In many cases, this meant having a disproportionately large share of their investments in perhaps a few stocks that had been in their lives longer than their children.  Adding to the risk,  many clients owned several similar stocks in the same sector with the same problem, such as perhaps 3 or 4 Canadian bank stocks they’d first started acquiring when the first Trudeau was doing his thing.

All that has now changed. Although you may still love your BMO or Royal Bank shares, it may now be possible to trim those positions in favour of a new infatuation. It doesn’t mean abandoning all of those legacy stocks, but merely hedging your bets. Although playing the field is not a great recipe for romantic success, investing is an entirely different kettle of fish. Rather than just looking at the tax side of things, you might be better off focusing on building a properly diversified portfolio that fits like a glove even if it means cutting an extra cheque to Ottawa in order to make this happen.

If you are looking to rebalance, perhaps this is the time to add a few new types of investments to your portfolio, particularly:

  • some that don’t trade on the stock market and hopefully haven’t taken as strong a gut punch to their prices as public market stocks have suffered;
  • expanding your portfolio geographically beyond just Canadian dividend payers and some companies from down in Trumpland;
  • investments that offer some downside protect through options or the ability to short-sell or which are designed to allegedly make money in any market conditions, although this doesn’t always happen.

The current buzzword is that people should “invest like a pension” and strive for less risk and smoother returns by expanding their mix of investments. Although even pension funds or companies that invest like them have taken a kick to the teeth this last month, their extra levels of diversification have generally helped them some of those extra body blows that the average Joe has endured.

Look to Refinance Loans

For those of us with mortgages, one of the consolation prizes (albeit one on par with a getting a participation ribbon for finishing  58th place in a 5 km race) are much lower borrowing rates. If you have loans of any type, get professional advice regarding whether it makes sense to redo those loans at current rates despite any penalties that might apply.  For those of us with variable loans, the monthly savings can be really significant and will hopefully help ease the pain for years to come.

For those of us with family trusts and loans at 2%, start planning to refinance those loans at 1% this July, as it appears very likely that the minimum loan rate will drop back to 1% at that time.  This will also apply to spouse loans as well, so it’s worth looking at updating those too. Despite the hassle, it’s recommended that you actually physically repay past loans and then re-advance the funds.

This will allow more future investment income to be taxed in low-income family members’ hands and less in yours at your higher rates.

Consider Setting Up a Family Trust or a Spousal Loan

If the rates do drop to 1% in July (this will be clear by the end of April and is based on a government formula that suggests that this will happen with room to spare), then those of us with large unregistered investment portfolios have the opportunity to income-split a lot more successfully with spouses, children and other lower income family members. Noting the current yields on many investments and the hope of stocks eventually recapture some of their past glories, the tax savings from loans to family investment trusts or spouses are even more mouthwatering. Until now, the unrealized gains on the higher income spouse’s portfolios may have been a deal breaker, as it meant paying too much tax to free up the capital to loan to your spouse or trust. For better or for worse, this may no longer be the case, both because of reduced gains and perhaps if the higher income spouse is in a lower tax bracket this year.

Be Prudent If Investing New Money into the Market Today

Although current yields on many investments are (apologies to my vegetarian, vegan or pescatarian readers) as mouthwatering as prime rib on a cold winter’s day, there is still a lot of uncertainty in the market. Although it is a personal decision as to whether you wish to deploy any dry powder you may have to take advantage of these eye-popping yields, do keep in mind that we might not have seen the bottom and it’s hard to determine how the fallout will affect different stocks and industries. Consequently, you may wish to keep in mind some of the following if you’re contemplating dipping a toe back into today’s rather frothy investment waters:

  • Consider dollar cost averaging rather than trying to do market timing. We don’t know if we’ve hit the bottom so you may benefit from easing money bank into the market over a number of weeks or months rather than going “all in” on what your fortune teller says is your lucky day.
  • Yield is a wonderful thing. If you do want to put new cash into the market, take advantage of those high yields rather than counting on future gains. The income will reduce the risk and can be redeployed back into the market if you so desire or can be a way of providing more money for your family during a time when many family budgets will be stretched extremely thin. Because of the current calamity, even blue-chip stocks have yields formerly reserved for junk bonds. As a result, there is no need to travel too far down the risk spectrum just to get a few more percentage points when safer stocks are already paying you handsomely
  • Be sure that you have a sufficient contingency fund set aside to cover you and your family’s expenses so you’re not stuck having to sell some of those investments you just purchased at the worst possible time. If in doubt, bump  up the size of the contingency fund.
  • Be even more conservative if you are borrowing to invest. Although rates are astonishingly low right now, leveraged investing only works if you can pay back your loans when the time comes. Accordingly, think long and hard before proceeding and reread my last three bullets at least twice. I strongly suggest staying away from margin accounts at this point as a margin call might ultimately be the financial kiss of death. If you do borrow to invest, carefully investigate the spread between secured lines of credits and borrowing using a traditional mortgage. Despite the decrease in rates, there can still be a big difference in cost between borrowing using a HLOC or using a mortgage. Although the mortgage option is less flexible and requires you to also pay down some of the principal with each payment, it might still be the way to go.
  • Diversify, diversify, diversify. Because the fallout is still so uncertain, spread your money over many different sectors and investments. It’s better to take some of the risk off the table by hedging your bets. Rather than waiting for fair weather and your ship to come in, consider funding a fleet of smaller boats that will see you safely into the future even if some of them don’t ever reach the shore.

Look into Estate Freezes

An estate freeze is a strategy that involves owners of private companies swapping their common shares for fixed value preferred shares. New common shares are then issued to other family members or to a family trust and all future increases in company value will be taxed in their hands. Private business owners do this sort of thing this for a couple reasons:

  • To increase how much capital gains can be sheltered from tax if the business is sold. If the existing shareholders won’t be able to shelter all the gains from tax upon sale under their own lifetime capital gains exemptions, having new growth taxed in other’s hands allows these other family members to dip into their own exemptions to increase tax sheltering at that time.
  • To minimize the tax bill on their deaths by capping the value of their shares and transferring future growth to younger generations.

Despite not owning a private company, are you the proud owner of a non-registered investment or real estate portfolio that you want to pass along to your kids, grandkids or favourite financial planner? An estate freeze might still be the thing for you. Transferring those assets into your company on a tax-free rollover basis in exchange for fixed value preferred shares lets any future growth accrue inside a family trust or in your heirs’ hands rather than yours.  As a result, when your time comes, you can pass into the great beyond knowing that your final tax bill is a lot smaller and your heirs’ inheritance that much larger than might have been the case.

In most of this instances, estate freezes only work if the new common shares subsequently grow in value.  Accordingly, doing a freeze this year when share prices for most private and public companies are at Black Friday prices can mean tremendous tax savings in years to come if values do bounce back, particularly if tax rates and the inclusion rate are both higher in the future.

Learn About Your Options

Keep informed about government programs and tax changes that might help you and your family, such as EI, reduced RRIF withdrawal requirements, extensions to tax filing and installment payments, changes to your bank rates, mortgage or loan deferral options and so much more.

Conclusion

I am hoping that one day, hopefully soon, we can look back on today’s events in the same way many of us look back on 2008 and 2009 and perhaps how my parents viewed my teenage years – incredibly trying and stressful, but something we all survived and put behind us.  I’ve tried to give you a lot to think about but there are so many moving parts and uncertainty that this is probably a good time to get professional advice before taking any big steps. In the meantime, let’s just focus on being good to each other and realizing that we’re all in it together.

Mar 24

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Volatility Part 2 – Enjoying the Merry-Go-Round Rather than Enduring the Roller Coaster

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As I expressed in my last article, for retirees, volatility is a lot like that glamorous, thrill-seeking friend of your youth hated by parents everywhere: a lot of fun when things were going well, but prone to cause trouble, unreliable and, in the end, far more trouble than they were worth. In other words, the sort of thing we hopefully grow out of when we’re older and wiser.

In the world of retirement planning, unpredictability is like the common cold – unwanted, unpleasant and, although the symptoms can be managed, there is no real cure. Unless you’re unwilling to court other risks by investing exclusively in GICs or the like, volatility may be something you have to learn to tolerate, just like a runny nose. Any investment whose returns are not completely predictable, constant and guaranteed, requires accepting an element of unpredictability. Although this uncertainty can certainly work in our favour when the markets soar and our investments grow like a teenaged boy with an endless appetite, if we are already on track to live the retirement of our dreams before this unexpected bonanza, then these unexpected gains really won’t have benefited us too much. On the other hand, in order to get these large gains in value, it is usually necessary to court the risk of large losses instead. As I illustrated in my last article, unpredictable results that vary widely from year-to-year can turn your golden years into problem ones even if your so-called “average returns” are solid if the sequence of good years and bad years work against you, such as if you have some bad years early into retirement and are forced to liquidate savings for living expenses along the way before things pick up again.

Let’s look at this in a slightly different way and return to one of the basic lessons of mathematics – the shortest distance between two points is a straight line. This is also true for retirement planning. If you can use a straight line to illustrate your portfolio’s investment returns each year (which means earning exactly the same amount each year), it is pretty easy to predict the outcome if your other variables also toe the line. Unfortunately, life doesn’t work like that – instead of a constant 6 or 7% per year, returns will be inconsistent and the straight-line of our dreams will be replaced with something that may more closely resemble the random scratchings of a 3-year-old. On the other hand, although we may never be able to get that ruler-straight line, we may be able to organize our investments so that this line goes up and down in gentle hills and valleys, never straying more than a few percentages from the targeted average, rather than the wild peaks and troughs that indicate huge gains and losses that more closely resemble a mountain range. Put another way, we want to reduce the yearly, unpredictable fluctuates in portfolio returns or its volatility as much as possible, as the closer each year’s actual returns are to the portfolio’s average return, the less likely we will run out of money when we need it most. Thus, although the sequence of returns is vitally important, we can minimize their impact by reducing the overall volatility of our portfolios so that the bad years are hopefully never bad enough to scupper all our retirement plans, regardless of when they occur.

In order to illustrate this mathematically, I wish to borrow from some projections prepared by Newport Private Wealth¹, a firm that manages money for many high-net-worth clients across Canada and with which I have a referral arrangement. They tracked two investors, each with $2,000,000 portfolios and 7% average returns. Each withdrew $80,000 per year and experienced 2% fixed annual inflation and needed the money to last for 25 years. In fact, the only real difference between the two portfolios was the degree of volatility. One portfolio had 5% volatility (i.e. each year’s return was between 2% or 12% while still averaging 7% overall) while the other had 20% volatility (each year’s return was no less than -13% and no more than 27% while still averaging 7% over time). Newport then used something called a Monte Carlo Simulator to randomly vary investment results each year each portfolio within the ranges specified above within a normal probability distribution, while preserving an overall average return of 7% to see if each portfolio could pay out the full $80,000 plus inflation for 25 years. And they did this not once but 5,000 times. The results? The investor with the higher volatility had a 27% chance of running out of money while his more conservative counterpart reduced this risk to virtually 0%.

Think that 20% volatility is excessive? Think again. The TSX essentially had a volatility of over 22% over the last 5 years. While the investor with the 20% volatility would have also had scenarios among the 5,000 random projections that produced well more than the $80,000 plus inflation needed for retirement, (such as if there were several years of good returns early in retirement) you would need to ask yourself whether this extra gravy on top of a plate that is already full is also worth taking a 27% chance of running short of groceries.

Managing Volatility – What You Can Do

Assuming you have now decided to forsake the rollercoaster-like peaks and troughs of high volatility investments, how do you make this happen? If you wish to ride the low volatility merry-go-round, with only gentle rises and falls in investment returns, there are a number of steps you can take. Although there may be no single silver bullet, either working with the right investment professionals or taking some or all of the following steps yourself can take some of the guesswork out of retirement planning. Moreover, it is also important to realize that portfolios are not merely high or low volatility – there are an endless number of points between these two extremes. Thus, even if you are unable or unwilling to take all the steps listed below (as well as some of the others out there) to minimize volatility in your investing, you may at least want to turn down the volatility dial a little bit – as many investment professionals will tell you, it is actually possible to set up a portfolio with higher average returns while also taking some of the volatility risk off the table. Interested? Keep reading.

Controlling Correlation and Diversifying

One way of controlling overall portfolio volatility is owning different investment classes that don’t react the same way when experiencing the same market conditions. In other words, you are looking for investments that may actually rise, or at least hold their own, if all your bank stocks tumble so that the net effect to your portfolio isn’t as dire. Expressing this in investment-speak, if two asset classes are “positively correlated”, it means that they respond similarly to changes in the stock market. If their degree of correlation is 1.0, it means that they respond exactly the same way. If they move exactly opposite to each other, their correlation is -1.0. If their correlation is 0.0, however, there is no connection at all to their annual investment returns. Thus, if you want to protect yourself from unnecessary ups and down, you generally don’t want a lot of assets classes that have a strong positive correlation. On the other hand, a strong negative correlation is a wonderful thing while owning classes or sectors that are uncorrelated is also very useful.

Many investors believe that they are properly diversified by owning a mix of stocks and bonds. Unfortunately, according to another Newport study², people aren’t as protected as they may think. In fact, an 80% U.S. equity and U.S. bond 20% bond portfolio had a 1.00 correlation over essentially a 10-year period ending in December, 2015, while a 50/50 mix generated a strong .97 correlation and even a 20% equity, 80% bond portfolio had .64 correlation. Thus, even if you held mostly bonds (which I do not generally recommend), your bonds wouldn’t have helped you over that ten-year period if the market tanked.

Accordingly, the first step is ensuring that you diversify outside of just one country. For Canadians, this is also important because we don’t have a lot of Canadian options for some of the other different investment sectors, such as high tech and pharmaceuticals, in the first place. Secondly, I also suggest looking outside the world of publicly traded-stocks and bonds, as they certainly aren’t the only game in town, even if the banks and their mutual funds may lead you to believe otherwise. Some additional options to investigate are private infrastructure projects, private debt, investing in private companies, owning private real estate funds (as well as potentially your own investment properties in some cases). Quite simply, there are a lot of other ways of investing your money than through public stocks or bonds. By doing so, you can lower your portfolio’s overall volatility because of a weaker correlation between these alternative investments and public ones, in addition to the fact that many private investments have a far lower overall volatility in the first place. In addition to investing through an exempt market advisor, such as through Klint Rodgers of Pinnacle Exempt Market Dealers (another referral partner of mine), clients can often also get exposure to alternative investments through private wealth management companies such as Newport.

There are other risks for different types of investments – again, there is no silver bullet out there – but by minimizing your risk to any one type of risk, even if it means taking on some different types of risks with part of your portfolio, you are still increasing the chances of overall success, provided you diversify intelligently. Although diversification can be a lifeline for your retirement dreams should the public markets crash, it only works if your alternative investment choices are sound ones. Although there are many private market investments that I love, there are also others that I wouldn’t touch with a ten-foot pole.

Be a Beta Blocker

Besides constructing a public equity stock portfolio that includes a diverse mix of investments from different sectors and parts of the world, the volatility-adverse investor may also wish to narrow his stock picks to those boring, solid, mature businesses that have a strong record of consistent earnings. Although those companies won’t do as well during the good times, they won’t suffer as much when the sky is grey, which is far more important when investing during retirement. In other words, blue chip stocks are probably a better choice than shares in that junior gold stock you heard about in the golf course lounge. They even have a stat that tracks how much a stock moves up and down relative to the stock market as a whole, which you may wish to investigate called “beta.”

A stock with a beta of 1.0 moves up and down with the same volatility of the stock market to which it belongs, while one with a beta of 2.0 moves up or down twice as much as the stock market. On the other hand, a stock with a beta of only .5 would only suffer 50% of a market’s losses but would only reap 50% of its gains. For example, if the market went up by 10% in one year, a 1.0 beta stock would generally also increase in value by 10%, a 2.0 beta stock would grow by 20% and a .5 beta investment would increase by 5%.

It is also possible to have negative beta stocks, or those who move in opposite directions to the market as a whole. Using the previous example of a year when the market grew by 10%, a -1.0 beta stock would shrink by 10%, a -2.0 beta stock would decrease by 20% and a -.5% beta pick would decrease by 5%. Accordingly, building on the previous section and the goal of setting up a portfolio that is properly diversified, using both low beta stocks, as well including some that do well when the market as a whole suffers both make sense. Unfortunately, as investment types like to say, past results do not guarantee future performance. This also applies to beta. Stocks with a low beta to date may slowly grow riskier or those that were high beta in their start-up phase may become a lot safer once they have both feet firmly planted. This both means that using beta to set up a portfolio is more of a guide than a guarantee and that it is necessary to continue to track a stock’s beta over time.

Show Me The Money

One of my favourite ways of minimizing volatility is to own investments that pay me as I go. I suggest this for several reasons. First, during retirement, the more income you receive from your portfolio each year, the less capital you will need to liquidate in order to fund your lifestyle. As one of the biggest investment risks during retirement is being forced to “sell low” in order to pay for that week’s groceries, more income means more time for the rest of your portfolio to bounce back during those inevitable recessions.

Secondly, I’ve found that more income means less worry for most clients. The more income they generate, the less they worry about market ups and downs, as growth isn’t as important. This is also one of the other reasons I love private market investments – they can often pay out substantially more than most public market investments.

As an aside, although exempt market exemptions may be considered high risk – and this is certainly true in some cases – I have a hard time accepting that such a diverse array of investment offerings all have exactly the same risk profile. I prefer to think about private offerings in the same way as I view public market investing – each needs to be judged on its own merits. Although there are some that I would never touch, I am far more comfortable with many private market investments offering regular, significant income payments to investors with a sound business plan, a sterling track record that has been vetted by outsiders and which is structured to align its interests with its investors than with many public stocks.

Returning to the public market, those same blue chip stocks discussed previously also often pay out handsome dividend streams, which can be tax-advantaged for investors in the right tax brackets who aren’t worried about OAS clawback. Finally, if you haven’t heard of MICs (Mortgage Investment Corporations) and REITs (Real Estate Income Trusts), then I suggest taking the time to learn more about both. These investments can generally pay out significantly higher yields than many dividend payers and may provide diversity. Both are real estate plays. They can be investments that trade on the public market or private investments. They may be Canadian investments but it is also possible to own US real estate in Canadian REITs as well. Moreover, REIT also vary according to the type of real estate owned in addition to geographically. For example, there are REITs that invest in: apartment buildings, office buildings, industrial buildings, retail properties and retirement homes. As an added bonus, many REITs are able to pay out some or all of their distributions as “return of capital”, which is tax-free until you’ve received all of your original investment back, although it will probably mean paying more capital gains tax later when you sell your REIT.

I also like using Options as a way of both protecting portfolios from sudden crashes in value and to also generate extra income during times of higher volatility. Although many people seem to automatically assume that Options mean taking on higher risk and volatility, this is not true. Although there are some pretty high risk Options strategies circulating through the investment world, Options can also be used to take volatility off the table. I particularly like using “covered calls” (as I have written about previously) which involves selling some of the potential upside on stocks you already own over a stated period, in exchange for cash on the barrel now. Although you may miss out on some of the run ups in value in the good times, you increase your cash flow, which decreases your overall volatility and the chances of having to sell capital during a down market. The amount you can receive for selling some of the upside varies according to market conditions. These payments, called “Options Premiums”, are actually the highest during periods of high volatility. If you want to know more about this, I suggest talking to Thomas Tsiaras of Industrial Alliance Securities Inc.in Vancouver, who does this for me and some of my clients, as most brokers do not offer their clients Options strategies.

On a final note, Options can also reduce volatility by minimizing your downside if you want to purchase this protection on all or some of your portfolio. This may be particularly valuable when investing in more volatile stocks or when you are worried about the market being overvalued but not wanting to convert your portfolio to cash in case you are wrong. Buying Call Options provides you with the right to sell stocks at a set price regardless of whether the actual trading price at that time is less than this value, thus capping how much you can lose on that stock since you can always sell at the call price if things are dire

Ultimately, while I believe that yield is your friend, it is only part of the mix when making investment decisions. While there are investments with significant yields that may be ideal for the right investor, a high yield can also be a potential warning sign in other instances. In other words, there might be a reason why a publicly traded stock is paying 10% per year, such as a recent fall in fortunes or the expectation that it will have to cut payments, or why a private market investment pays out so much.

Conclusion

Although volatility can make the good times better, it also means increasing the chances of life going horribly wrong. Although many of us focus solely on average rates of return, this rather misleading statistic paints a far from complete picture as I hope I hammered home in my last missive. In order to make an informed decision, it is essential to know the risks you need to take in order to get this return and how this may affect your retirement dreams. If your goal is to live, enjoy a secure, stress-free retirement that provides you with the best chance of success, then taking steps to minimize volatility should be a key part of this plan. The retirement you save just may be your own.

¹. Newport Private Wealth ( What the Smart Money Knows whitepaper, January 2016.)

². Newport Private Wealth ( What the Smart Money Knows presentation, January,2016).

 

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