Why invest in the first place?

I know you have been following along faithfully (of course!) and have set up an Automatic Savings Plan (ASP) that is currently going into investments. That means, each month, you are contributing a set amount of money into your accounts (RRSP, TFSA or non-registered) and investing them in either low-cost index mutual funds or Exchange Traded Funds (ETFs).  So the money is going to start rolling in, right? Wait… how exactly does the money start rolling in?

There are a couple ways to earn income on your investments:

  1. Interest from bonds. When you are lending money to either the government or corporate companies, they will, in return, pay you money for it. This is no different than when you are borrowing money from credit card companies or money for a mortgage from the bank; you will be paying them money (called interest) for the privilege of using it. Therefore, when you own bonds as investments, you will earn a steady income from it.
  2. Dividends from stocks. When you buy shares in a company, you are providing them with money that is ideally used to grow the company’s business, and consequently, help them increase the earnings and profits for the company. The board of the directors may then decide to share these earnings and profits with you, the shareholder. This payout is called dividends, and is usually quoted as a dollar amount per share. For example, if the company chooses to pay $0.25 per share, and you own 1,000 shares, expect to receive a dividend payment of $250. One thing to note about dividends is the ex-dividend date. It is the date in which you have to own shares in the company to be eligible for the dividend, which will be paid out at a later date. For example, say the ex-dividend date is February 23. If you own shares on February 22, you will be entitled to the dividend payout. If you buy the shares on February 23 (therefore not owning the shares on February 22), you will NOT be eligible for the next dividend payout.
  3. Capital gains. Ultimately, this is the main reason why most people invest in stocks (and ETFs and index mutual funds). If the company is earning money and profits, the value of the company is also (hopefully!) growing. As the value of the company increases, the cost of buying shares in the company also increases. Say you buy a share in company ABC today for $10. The company is profitable and in 2 years, a share in company ABC now costs $25 to own. A capital gain results when you buy a share at one price, and sell it later at a higher price. For example, say you bought a share in Company ABC for $10, and 2 years later, sell it to someone else for $25, then the capital gain for the investment will be $15 ($25 – $10 = $15). NOTE: This is a very simplistic view! Unfortunately, the above scenario does not always occur as the stock market is an entity that can fluctuate based on external factors such as government policies, economic environment, civil unrest or even just the popularity of a product or brand.

Clear as mud, right? 🙂 Hopefully, this will shed a bit of light on why people choose to invest their money in stock markets or ETFs or mutual funds in the first place.

Final question: Say you own shares in company ABC and you decide to sell them on February 23. If the ex-dividend date is February 23, will you be entitled to the dividend payout?

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Gassy Radical Robots Should Poo (GRRSP)

Yes, its late. I’m not that creative when I’m fully awake. Writing after midnight could prove disastrous.

So moving beyond pooing robots, Group Registered Retirement Savings Plans (GRRSP) are sponsored by employers. They are similar to RRSPs, but are administered by the employer. The great thing about these plans is that the contributions are made through deductions in your payroll. Ahhh! Less money from your paycheque! How is that a good thing? But it is good because this is one less thing you have to think about. Forced savings. I ❤ it. I’ve had lots of questions on these plans, usually referred to as that thingy that my employer has that I contribute to for retirement. I think. Anyways, if you are fortunate enough to have an employer who provides this, this is a great Level 4: Investment cheat.

How much should I contribute?

If your employer provides a match, contribute enough to get the full match. This is FREE MONEY that your employer IS THROWING AT YOU. If you need to contribute 4% to get a 4% match, contribute the FULL 4%. Think of it as an instant 4% pay raise, just for being you! Or, put another way, it is a 100% return on your money. Hard to beat that, I assure you.

What should I invest in?

Once you move beyond the initial procrastination and actually sign up, choosing your fund allocation could prove to be the next big deterrent.  I’ve heard of people randomly choosing a selection of funds from the list that the employer provides. Eeny Meeny Miny Moe. Spell check that all you want; Wikipedia says its right. Although this could prove to be entertaining, some may prefer a more systematic approach on selecting your investment allocation.

Step 1: Take your age (yes, your actual age, pretending is going to hurt no one but you). This is going to be your bond or fixed income portion. If your employer has a decent administrator, the list of similar types of funds should be grouped together. Go to the bond or fixed income section, and select the Canadian fund with the LOWEST MER. We all know why this is important. The one crappy thing about GRRSP is that you don’t have a choice on the selection of funds, although I have seen plans that provide index mutual funds selection. That alone was almost enough for me to want a job there. Almost. Or, you can make it your sole mission to advocate your employer to provide index mutual fund options. Those who complains the most and the loudest, wins. Those in the corporate world know what I’m talking about.

Step 2: Subtract your age from 100. Take this number and divide it by 3. Bear with me, this elementary math will soon be over. This number is going to be your allocation for your equities portion, and it will be split evenly amongst Canadian equities, US equities, and International equities. Once again, always look for the fund with the LOWEST MER.

That’s it. Take 5 minutes, sign up, and you will be well on your way towards a comfortable retirement.

As a recap, I’m 30. My portfolio is going to look like this:

24% Canadian equities

23% US equities

23% International equities

30% Canadian bonds/fixed income

Yes, I rounded up my Canadian equities so it adds to 100%. Yes, if your age doesn’t result in even numbers, you will have to do this.

How many of you have GRRSP? Are index mutual funds more common now than before? How many of you have these provided but are not a participant? If you are participating, are you maxing out the employer match?

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Tonight’s Smackdown: RRSP vs TFSA

When I ask people what they are invested in, I generally get two answers: a little bit of everything, or RRSPs. A little bit of everything seems to be a catch all and is a little discerning because it indicates that they’re not entirely sure, and/or that they lack specific investment goals. And RRSPs are not an investment. So let’s back up a bit and see if we can understand all these acronyms.

Registered Retirement Savings Plan (RRSP)

RRSPs are NOT an investment; they are an investment/savings vehicle. Put another way, imagine that you have a box that you are calling RRSPs. You can put investments, such as mutual funds, Guaranteed Investment Certificates (GICs), Exchange Traded Funds (ETFs), company stocks or shares, bonds, or even mortgage loans in this RRSP box of yours. The money that you contribute to RRSPs every year is tax deductible (for every dollar you contribute, your taxable income is reduced by a dollar during the year you make your contribution), and any earnings you receive from your investments are allowed to grow tax free. When you are eligible to retire, any withdrawals from your RRSP are taxed at 100%. Once you put money into your RRSP, and purchase your investments (mutual funds, ETFs, etc.) you are able to buy or sell any of your investments. There is a limit to how much you can contribute every year (18% of your earned income from the previous year up to a designated max), and if you do not make a contribution during the year, you can carry forward that amount and contribute that amount in the future.

My “two cents” on RRSPs:

–          DO NOT take out a loan to contribute to a RRSP. Your advisor/banker will advise you to do this to get the tax write off, but it really just pads their pockets. Yes, I know, interest rates are low, get a nice cheque back from government blah blah blah, but no. Sit down with me, and I would ❤ to run the numbers with you. An excuse to play with excel? Seriously, it would make my day.

–          Instead, figure out how much you want to contribute to a RRSP. Then, set up an ASP (automated savings plan) and have this money withdrawn from your chequing account each month. At the end of the year, you take this lump sum and make your contribution. Or set up an ASP to contribute automatically into a low-cost index mutual fund. This would be the best course of action for most people.

–          DO NOT make withdrawals on your RRSP before you retire. The current rules allow you to make tax-free withdrawals if you buy your first home (Home Buyer’s Plan), or want to go back to go back to school (Lifelong Learning Plan). There are rules on how much you can withdraw and how long you have to pay it back, but you are interfering with the magical powers of compounding by doing this, thus sacrificing your future for immediate gratification. If you want to buy a home, save up for the 20% down payment. If you want to go back to school, save up for it.

–          It might not make sense to max out your RRSPs every year. The money might be better utilized elsewhere (TFSA or mortgage). This is completely dependent upon your financial situation!

Tax-Free Savings Account (TFSA)

Easily the best thing the government has ever done for us. Honestly. A TFSA is also a savings/investment vehicle (box) that you put investments in. Basically anything you can put into a RRSP, you can also put into a TFSA. Beginning January 1, 2009, anyone over the age of 18 can contribute $5,000 a year into their TFSA, and all the earnings can grow tax free. You can withdraw the money any time you want, and re-contribute the amount you withdrew as early as the following year! The best part? All withdrawals are taxed at 0%. That’s right. 0%!

My “two cents” on TFSAs:

–          Everyone should be taking advantage of this gift from the government! As of January 1, 2012, you would be able to contribute up to $20,000 per person (assuming you haven’t made any contributions before).

–          If you are saving for a car or a downpayment or a vacation, it might be better to shelter that money in here. Even with the awesomeness that is the ING Direct or PCF savings accounts, the government will be taking their cut of any interest you earn.

–          Perfect for retirement savings as well! When you retire, withdrawals from RRSPs will be counted towards your income for the year and taxed accordingly. The income may affect your eligibility for Old Age Security (OAS) or Guaranteed Income Supplement (GIS). Not so with money from TFSAs!

Final Question of the night: If you retire with a million dollars, would you want it in a RRSP, or in a TFSA?

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The REAL Cost of Mutual Funds

If I were to ask you what you are invested in, many would say they have mutual funds from their banks or investment companies. If I ask you how much it costs you every year to have these mutual funds, most would say “nothing.” Step back and think about this. Are all these companies and their financial advisers working for free to ensure your financial success? Are all these advisers working for non-profit companies?

Enter MERs (Management Expense Ratios). It includes expenses that are incurred to operate the mutual fund, such as investment management fees, marketing and administrative fees, as well as the fees they pay to the advisers that sell the mutual funds (trailer fees). They are expressed as a percentage of your mutual fund’s value, and this is the yearly cost of your mutual fund. Never heard of them? Not surprised; most are unaware that MERs even exist! These fees are subtracted off the fund return every year, whether or not the fund makes or loses money.

What does this mean? Say you have $100K invested in mutual funds with a MER of 2.5%, which is the average MER in Canada. We are fortunate to live in a country that provides mutual funds with the highest MERs in the world! (Average MER in US is about 1.1%). So how much does this cost you every year? $2,500! Every year. The stock market moves up and down so your mutual fund value will increase in some years, decrease in others. The one thing that remains consistent is that the mutual fund will take their $2,500 (approximately; the 2.5% is based on your fund value, so if your funds go up, you will be paying more than $2,500, and vice versa) every year without fail. Own it for 5 years, and you would have paid the mutual fund company $12,500. Shocking isn’t it? This doesn’t take into account the other fees (called loads) that are slapped on as well (front loads, back loads, deferred sales charges). But let’s focus on one thing at a time.

So let’s assume we invest $100K in Franklin Templeton’s Quotential Balanced Growth Portfolio at the beginning of 2006 and did not touch it for 5 years. The returns were taken from here: http://www.franklintempleton.ca/ca/retail/en/pdf/downloads/advisormonthly/fundreports/pub/658.pdf

Based on the footnote, the annual return is the total return for the year, and does not take into account the MER (based on my understanding). If the annual return does already include the MER, the numbers would change, but the resulting message will remain the same. To simplify the calculation, we will assume that the annual cost is based on the value at the beginning of the year (ie, for 2006, the annual cost is $100K x 2.24% = $2,240).

Year

Beginning of year

Annual Return

MER

Actual Return

End of year

Annual Cost

2006

100,000

9.90%

2.24%

7.66%

      107,660

             2,240

2007

107,660

-0.20%

2.24%

-2.44%

      105,033

             2,412

2008

105,033

-25.40%

2.24%

-27.64%

         76,002

             2,353

2009

76,002

25.50%

2.24%

23.26%

         93,680

             1,702

2010

93,680

9.60%

2.24%

7.36%

      100,575

             2,098

 

           10,805

AHHHH numbers! For those who hate numbers, ignore the calculation and skip right to the comments. For those who feel naked if you don’t have your trusted calculator with you, please confirm my calculation! 🙂

Ultimately, we have $100,575 at the end of 5 years, which results in a gain of $575 for our initial $100,000 investment. How much did the mutual fund company earn over the same 5 years from our account? $10,805. I wasn’t able to track down what Franklin Templeton pays its advisers to sell us this fund (it can be found in the prospectus but my Google skills failed me), but I’ve found that the trailing fees could be up to 1% of the asset value for every year you hold it. So we’ll just make this assumption for this analysis. What’s the verdict? You make $575 over 5 years, and your trusted financial advisor pockets over $4,800. Sweet deal, hey? Sign me up!

So why does Canada have the highest MERs in the world? Cause we’re willing to pay for it. If we’re willing to pay for it, why in the world would a company reduce their fees? Voluntarily reduce the amount of money that goes into their pockets? As investors, we need to become aware of the fees that we are paying, and choose funds with lower MERs. What frustrates me the most is that most people do not even know what they’re paying every year! If the investor is fully aware of the MER and is willing to pay it because they believe that the fund manager will outperform the market, then kudos to them. Unfortunately, most are just blissfully unaware. Pretty expensive bliss though, hey?

So how do you find out how much you are paying? The fees are disclosed in the prospectus and annual reports that EVERYONE reads, right? I found a simplified prospectus – it was ONLY 224 pages. Buried in there is all the information about how much the mutual fund is ACTUALLY costing you. Buyer beware, right? Otherwise, a quick search on Google should result in some answers.

Have you heard of MERs before? What mutual funds do you currently have? What are the MERs that you are paying? Please share below and take a look at what your family and friends are paying every year. If you have trouble finding the MER for your mutual fund, post a comment and I will try my best to track it down for you.