Investing Fundamentals: Asset Allocation and Tax Strategy

Professional Development Course Investing Fundamentals: Asset Allocation and Tax Strategy COPYRIGHT Chartered Professional Accountants of British Columbia All rights reserved. No part of this publication/course material may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means (photocopying, electronic, mechanical, recording or otherwise) without the prior written permission of the copyright holder and publisher, applications for which shall be made to the Chartered Professional Accountants of British Columbia, 800-555 West Hastings Street, Vancouver, BC, V6B 4N6. DISCLAIMER This course material deals with complex matters and may not apply to particular facts and circumstances. As well, the course material and references contained therein reflect laws and practices which are subject to change. For these reasons, the course material should not be relied upon as a substitute for specialized professional advice in connection with any particular matter. Although the course material has been carefully prepared, neither the Chartered Professional Accountants of British Columbia, the course author and/or firm, nor any persons involved in the preparation and/or instruction of the material accepts legal responsibility for its contents or for any consequence arising from its use. January 2018

Welcome CPABC Chadwick Walker Investment Advisor, Odlum Brown Limited Michael Erez Director, Odlum Brown Financial Services Limited ODLUMBROWN.COM Member-Canadian Investor Protection Fund Investing for Generations Agenda: Part I Investment Fundamentals Building a Portfolio Approach and Examples 1

Agenda: Part II Types of Investment Accounts Asset Location Tax Tips You are probably wondering = Chadwick D. Walker, BSc, BEd, CIM Associate Portfolio Manager, Investment Advisor Direct: 604 844 5433 cwalker@odlumbrown.com 2

Limitless Financially Challenged Priorities 3

Amplified Focus Excited to be of service. Investing (n-vsting) Assets - Liabilities 4

Debt Vacations Charity Shopping Car Kids 15% Savings Account 10% 5% Source: Statistics Canada 0% May-89 May-99 May-09 Investments Bonds Annuity Property Equities Start Business 5

The Power of Compounding Year 1 Interest Year 2 Interest 6

Year 1 Year 20 Year 40 Year 60 Currency Risk $4.00 USD $5.00 CDN Purchasing Power Parity 7

2016 2017 $10.00 Inflation $10.50 5% 1950 2050 NOW Money Supply 8

Help Wanted! Canadian Inflation 14% 12.5% 12% 10% 8% 6% 2% 4% 2% Source: Statistics Canada 0% 1967 1977 1987 1997 2007 20% 15% 10% 5% Core Inflation Bank of Canada Source: Statistics Canada 0% 1967 1977 1987 1997 2007 2017 9

Current Lifestyle: $50,000.00 Future Lifestyle: $90,000.00 + Inflation (2% in 30 years) What about mortgages? 25% 20% 15% Conventional 5 year mortgage rate Overnight Bank Rate 10% 5% 0% 1982 1987 1992 1997 2002 2007 2012 Source: Bank of Canada 10

When should I start? One Diamond Equals One Year Average Human Lifetime 11

Average Human Lifetime Each row is one decade Birth 30 th Birthday 60 th Birthday Turning 90 Birth Investment Horizons Each row is one decade 25 65 40-year time horizon Financial Independence Birth Each row is one decade 35-year time horizon 65 100? 12

Price - $50k/year Retirement Lifestyle Costs $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 5% Net Growth Invest $10k per year from 25-65 Withdraw $50k/year starting at age 65 $0 25 35 45 55 65 75 85 95 105 $800 $700 $600 $500 $400 5% Net Growth Withdraw $50k/year starting at age 65 Invest $10k per year from 35-65 $300 $200 $100 $0 25 35 45 55 65 75 85 95 105 13

$1,600 $1,400 5% Net Growth Withdraw $50k/year starting at age 65 $1,200 $1,000 $800 $600 $400 $200 $0 25 35 45 55 65 75 85 95 105 Investing for Generations Risk Maximize Gains 14

Other Considerations Inflation Taxes Income Fees Debt Savings Risk Tolerance Fit? 15

Modern Portfolio Theory Return 25% Standard Deviation vs. Expected Return Security A: Expected Return = 12%, Standard Deviation = 20% Security B: Expected Return = 20%, Standard Deviation = 40% 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% 50% Risk 16

Optimizing Risk and Return Return Portfolio Combinations 20% 10% Portfolio A % B % Return Standard Deviation 1 1 0 12% 20% 2 0.9 0.1 13% 18% 3 0.76 0.24 14% 16% 4 0.5 0.5 16% 20% 0% 0% 10% 20% 30% 40% Risk 5 0.25 0.75 18% 29% 6 0 1 20% 40% Are humans perfectly rational? Asset Allocation 17

$800,000 ROI $200,000 BONDS ~5% EQUITIES 4% 10% $32,000 $20,000 $500,000 ROI $500,000 BONDS 7% EQUITIES 4% 10% $20,000 $50,000 $200,000 ROI $800,000 BONDS ~9% EQUITIES 4% 10% $8,000 $90,000 18

More Specific Shopping for Bonds 2-Year Government Bond % 15 10 5 0.51% 0 Jan-83 Jan-93 Jan-03 Jan-13 Source: Bank of Canada 19

15 10-Year Government Bond % 10 5 1.73% 0 Jan-83 Jan-93 Jan-03 Jan-13 Source: Bank of Canada 25% 20% 15% 10% 5% 0% Sep-07 Sep-10 Sep-13 Sep-16 Source: Bank of Canada High Yield 4.39% Bond Ladder 20

2023 Bond @ 5% 2022 Bond @ 4% 2021 Bond @ 3% 5 Years 2020 Bond @ 2% 2019 Bond @ 1% 2023 Bond @ 5% 2022 Bond @ 4% 2021 Bond @ 3% 2020 Bond @ 2% $$$$$$ Maturity $$$$$$ - 2024 Bond @6%,?? 2023 Bond @ 5% 2022 Bond @ 4% 2021 Bond @ 3% 2020 Bond @ 2% 21

After Tax Return Fixed Income $10,000 4% = $400 *Inflation 2% = -$200 *Taxes on $400 *50% = -$200 *Advisory Fees 0.5% = -$50 NET Total = $-50 *Estimated Costs Why do we need fixed income? Return of Capital Oppositely correlated to the markets Downside protection Interest income Equities Shopping for Equities 22

Index Composition Index of 6 companies for an exchange that has 11 companies trading 50 5 20 20 3 1 Index Composition Index of 6 companies Bigger Company = Bigger Weight 50 20 20 5 3 1 Global Choices 23

Canada S&P/TSX Index 20,000 6.4%* 15,000 10,000 5,000 0 Jan-80 Jan-90 Jan-00 Jan-10 *annualized over 15 years. Source: Market-Q Sector Weighting Financials Real Estate Materials Energy Industrials Consumer Discretionary Info Tech Consumer Staples Telecom Services Utilities Health Care 3,000 2,500 2,000 1,500 1,000 500 USA S&P 500 Index 0 1-Jan-80 1-Jan-90 1-Jan-00 1-Jan-10 Source: Market-Q 7.8%* *annualized over 15 years. 2 3 13.9 8.2 24.1 Sector Weighting (%) 14.8 2.9 3 12.2 5.8 10.1 Financials Real Estate Materials Energy Industrials Consumer Discretionary Info Tech Consumer Staples Telecom Services Utilities Health Care Build it Build a portfolio like an orchestra 24

Build it Financials Real Estate Materials Energy Industrials Consumer Discretionary Info Tech Consumer Staples Telecom Services Utilities Health Care Odlum Brown Model Portfolio The Odlum Brown Model Portfolio was established by the Research Department in December 1994, with a hypothetical investment of $250,000. These are gross figures before fees. Past performance is not indicative of future performance. Trades are made using the closing price on the day a change is announced. Data as of Dec. 15, 2017. After Tax Return Equities* $10,000 Invested 11% = $1100 Inflation 2% = -$200 Tax on $550 (1/2 gain) 50% = -$225 Advisory Fees 2% = -$200 NET Total = $475 *Estimated costs. 25

BONDS EQUITIES TOTAL RETURN Research Approach 26

High-Quality Companies 27

Putting all the companies together $7,000,000 $6,000,000 $5,000,000 Symphony of Returns Symphony of Returns 1 1 26x $4,000,000 $3,000,000 $2,000,000 2 2 9x $1,000,000 3 $250,000 $0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 3 7x 1 As of December 15, 2017. The Odlum Brown Model Portfolio was established on December 15, 1994 with a hypothetical investment of $250,000. Performance figures do not include any allowance for fees. Past January 8, 2018 83 performance is not indicative of future performance. Trades are made using the closing price on the day a change is announced. 2 S&P 500 Total Return Index in Canadian dollar terms. 3 S&P/TSX Total Return Index. Recap Personal Risk Time Horizon Future Goals & Values Assets to own 28

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Location, Location, Location! Michael Erez, CPA, CGA, CFP Director, Odlum Brown Financial Services Limited ODLUMBROWN.COM Member-Canadian Investor Protection Fund Where should your investments go? Which investments to will hold in which optimize accounts tax efficiency? to optimize tax efficiency? $ $ 1

What is Financial Planning? Asset Management Risk Management Retirement Planning Tax Planning Estate Planning A framework for decision making Meet Dave & Lisa Age 45 Goals Retire in 15 years Pay off mortgage by retirement Help fund kids post secondary education Dave & Lisa want to know How to allocate $45K this year Invest or pay down mortgage? 1 4 Spousal RRSP? Which accounts? (RRSP, TFSA, RESP etc.) 2 5 What should Lisa do with her locked in RRSP? Which investments in which accounts? 3 6 Hold assets in joint name? 7 When should they convert their RRSPs to RRIFs? 2

Asset Location INVESTMENT ACCOUNTS Types & Features FRAMEWORK How to Allocate Funds FRAMEWORK Where to Put Investments PLANNING TIPS By Account Investment Account Types Non Registered (Taxable) Registered LIRA Estate LIF Joint TFSA LRIF Corporate RESP RDSP Non Reg Accounts vs. RRSP & TFSA Contributions Non registered RRSP/RRIF TFSA Maximum age Age 71* No limit Annual limit (2018) Unlimited $26,230 $5,500 Cumulative limit (2018) $57,500 Carry forward room Yes Yes Withdrawals added to contribution room No Yes (Following year) Penalty on excess 1% per month 1% per month 3

Non Reg Accounts vs. RRSP & TFSA Taxation Non registered RRSP/RRIF TFSA Contributions Deductible Income & growth Withdrawals Taxable Only if disposition triggers capital gain Deferred until withdrawn Fully taxable Tax free Except: foreign withholding tax Tax free Upon death Capital gain/loss Except: spousal rollover Fully taxable Except: spousal rollover Tax free Asset Location INVESTMENT ACCOUNTS Types & Features FRAMEWORK How to Allocate Funds FRAMEWORK Where to Put Investments PLANNING TIPS By Account Dave & Lisa $570K invested $700K mortgage Have $45K to allocate this year 4

Framework for allocating funds Start with goals: What s most important to you? What are the easy wins? Mortgage vs. investments? Retirement accounts vs. RESP? RRSP vs. TFSA vs. non registered? Mortgage vs. Investments Rates on mortgage vs. investments (Mortgage rate is after tax) When do you want to be debt free? Mortgage vs. Investments What keeps you up at night? 5

Mortgage vs. Investments 19.5 years Pay down mortgage in 15 years Extra payment of $10K/year required Caution build in future rate increases! RESP Do you want to fund kids entire education OR just help out? How much do you currently have saved? How much grant (CESG) room is available? $2,500 Contribution $500 CESG (up to $50,000) (up to $7,200) RRSP vs. TFSA: Marginal tax rates Now vs. Retirement Now > Retirement Now = Retirement Retirement > Now RRSP RRSP = TFSA TFSA Both, if possible 6

RRSP vs. TFSA: Account Balance & Length of Retirement Example: Smaller balance Less risk of withdrawing @ higher rate Longer retirement More time to income smooth RRSP Lower rate in retirement = RRSP Tax & additional information Dave Lisa Income $250,000 $70,000 Marginal tax rate (MTR) 49.8% 28.2% RRSP Room $40,000 $64,000 TFSA Room $15,000 $15,000 Current Investment Balances Investments Dave Lisa Total RRSP $330,000 $90,000 $420,000 Locked RRSP 30,000 30,000 TFSA 45,000 45,000 90,000 Non registered 30,000 30,000 Personal investments $405,000 $165,000 $570,000 *Excludes RESP 7

After Spousal RRSP Contribution Investments Dave Lisa Total RRSP $330,000 $120,000 $450,000 Locked RRSP 30,000 30,000 TFSA 45,000 45,000 90,000 Non registered 30,000 30,000 Personal investments $405,000 $195,000 $600,000 Retiring before 65: Spousal RRSP Contribution Dave claims the deduction Fund Allocation Summary Based on Dave and Lisa s goals Pay off mortgage by retirement $5K Help fund kids education with RESP $30K Retire in 15 years (RRSP) $30K $5K $10K Run a financial projection: Is desired retirement spending sustainable? Asset Location FRAMEWORK How to Allocate Funds Tax Treatment of Investment Income FRAMEWORK Where to Put Investments 8

Investment Income Comparison Interest income Foreign dividends Non registered (taxable) accounts Eligible dividends Capital gains Tax Treatment Interest income Foreign income Fully taxable @ marginal rates Eligible dividends Capital gains Tax Treatment Interest income Foreign income Eligible dividends Capital gains Fully taxable @ marginal rates + Foreign withholding tax Foreign tax credit(?) 9

Foreign Withholding Tax Rate Rates vary based on tax treaty. 15% most accounts (i.e. Non reg, TFSA, RESP, RDSP) Exception 0% on RRSP/RRIF/Locked 0% all accounts 35% all accounts Tax Treatment Interest income Foreign dividends Eligible dividends Capital gains Grossed up amount taxable @ marginal rates Enhanced DTC Top effective rate = 34.2% (vs. 49.8%) Tax Treatment Interest income Foreign dividends Eligible dividends Capital gains 50% taxable @ marginal rates Top effective rate = 24.9% (vs. 49.8%) 10

Tax Rates & After Tax Yields Interest & Foreign Income Eligible Dividends Capital Gains Top marginal tax rate 49.8% 34.2% 24.9% Example Pre tax amount to provide $10,000 after tax $19,920 $15,198 $13,316 Tax Rates & After Tax Yields Take home message: Don t need to earn as much in capital gains or eligible dividends to get the same after tax return on interest or foreign income. Example But... Don t let the tax tail wag the investment dog! Asset Location INVESTMENT ACCOUNTS Types & Features FRAMEWORK How to Allocate Funds FRAMEWORK Where to Put Investments PLANNING TIPS By Account 11

Traditional Rules of Thumb Put Investments that pay Interest & foreign income Fully taxable Eligible dividends & capital gains At lower marginal effective tax rate Large capital gains (High growth equity) Into These accounts Registered accounts (RRSP/RRIF) Withdrawals fully taxable Character of income is not retained Non registered accounts Character is retained TFSA Tax free General Guidelines Only No one size fits all Complexity varies w/: # of accounts investment type Real life is messy Optimal location considerations 1. Tax rate 2. Time horizon 3. Liquidity 4. Turnover All interconnected 12

Tax Rate Marginal Tax Rate (MTR) Rate of tax you pay on an additional dollar of income Marginal Effective Tax Rate (METR) MTR + impact of tax deductions, credits & income tested benefits Example OAS Clawback: $0.15 per $1 of net income >$75K (upto $122K) Tax Rate Impact on current & future tax rates Higher Current METR More sensitive to highly taxable investments in taxable accounts (i.e. bonds, foreign dividend paying stocks) Lower income vs. Higher income years Assess impact of each type of income/gain on METR Eligible dividends vs. capital gains < $110K > Combined Federal & BC MTR (2018) Taxable Income Interest, Foreign Div Capital Gains Eligible Dividends $40,000 22.7% 11.4% > (3.2%) $60,000 28.2% 14.1% 4.4% $80,000 31.0% 15.5% 8.3% $100,000 38.3% 19.2% 18.3% $110,630 40.7% 20.5% < 21.6% $150,000 45.8% 22.9% 28.7% $205,000 49.8% 24.9% 34.2% 13

Time Horizon Accumulation Asset allocation & location Withdrawal Liquidity How much cash do you need & when do you need it? If in the short term TFSA: No tax, but using up scarce room RRSP: Taxable withdrawal Consider if retired or in lower tax bracket Non reg: No tax on withdrawals Consider unrealized gains Turnover A measure of how often assets are bought & sold Higher turnover More frequent taxable capital gains Tax drag (Lower compounded returns) For securities with expected capital appreciation: Buy & hold: Non registered account is suitable Active trader: Tax sheltered account (RRSP/TFSA) preferred 14

Dave & Lisa s Accounts RRSPs (incl. $30K contribution) TFSAs Non registered (Dave s name) $480,000 90,000 30,000 Total $600,000 *RESP excluded Dave & Lisa s Investments Cash Fixed income High growth equity Dividend paying stock: CDN Foreign (incl. US) 2.5% 37.5% 20.0% 20.0% 20.0% $ 15,000 225,000 120,000 120,000 120,000 Total $600,000 Dave & Lisa Investments ($000 s) TFSA Non reg RRSP Total Cash 15 Fixed Income 225 High Growth Equity 120 Dividend Paying Equity Canadian 120 Foreign (U.S.) 120 Total $90 $30 $480 $600 15

What If... Dave wasn t a buy and hold investor? High turnover in non registered account Ongoing taxable capital gains... at high rates RRSP > Non registered Combined Federal & BC MTR (2018) Taxable income RRIF Eligible Dividends $40,000 22.7% (3.2%) $60,000 28.2% 4.4% $80,000 31.0% 8.3% $100,000 38.3% 18.3% $150,000 45.8% 28.7% $205,000 49.8% 34.2% What If... Dave was in Lisa s tax bracket ($70K)? Current MTR on dividends Likely < MTR on future RRIF withdrawals Non registered > RRSP 16

Combined Fed & BC MTR (2018) Taxable income RRIF Eligible Dividends $40,000 22.7% (3.2%) $60,000 28.2% 4.4% $80,000 31.0% 8.3% $100,000 38.3% 18.3% $150,000 45.8% 28.7% $205,000 49.8% 34.2% Dave & Lisa Tax Rate Investments ($000 s) TFSA Non reg RRSP Total Cash 10 5 15 Fixed Income 225 225 High Growth Equity 90 20 10 120 Dividend Paying Equity Canadian 120 120 Foreign (U.S.) 120 120 Total $90 $30 $480 $600 What If... Capital gains inclusion rate increases to 75%? Interest rates go up? Dave & Lisa take a year off? They are now 70 and retired? They want to help their kids with a down payment? Tax Rate Time Horizon Liquidity Turnover 17

Asset Location INVESTMENT ACCOUNTS Types & Features FRAMEWORK How to Allocate Funds FRAMEWORK Where to Put Investments PLANNING TIPS By Account Planning Tips (By Account) Planning Areas Income Tax Estate Objectives Minimize and defer tax Accumulation, retirement and death Avoid probate Process and fee Non Registered Joint account(s) with spouse Impact on income taxation? No. Don t forget about attribution! Right of survivorship Avoid probate Can have multiple joint accounts Dave and Lisa? 18

RRSP Higher earning spouse should maximize contributions first Regardless of whether contributing to personal or spousal RRSP Deduction at higher marginal rate = more savings Dave and Lisa? RRSP / RRIF Pension income splitting for RRIF (& LIF) income: Age 65+ If considering early retirement (< age 65): Balance both spouses RRSPs for future income splitting Dave and Lisa? Spousal RRSP Withdrawals from Spousal RRSP attributed to contributor to the extent made in: The year of spousal contribution 2 years after Exception: No attribution on RRIF minimums 19

RRSP RRIF (Conversion) No change in investments required Conversion must be done by age 71 (Dec 31 st ) Possible at any younger age Under age 71: Does NOT have to be all or none! Mandatory annual minimum withdrawals (next slide) RRIF Withdrawal Minimums Age* (%) 60 3.33 65 4.00 70 5.00 71 5.28 75 5.82 80 6.82 85 8.51 90 11.92 95+ 20.00 Min = [RRIF balance x %] Example at age 71: $100,000 x 5.28% = $5,280 *As of January 1. RRSP RRIF (Conversion) Consider conversion @ age 65 (full or partial) If already retired & spouse has lower taxable income RRIF income age 65: Pension income splitting &tax credit Base RRIF on younger spouse s age Lower RRIF minimum withdrawals (see table) More flexibility & control over taxable income/oas clawback 20

Locked in RRSPs (LIRA, LIF, LRIF) Refresher Originate from Defined Contribution (DC) pension plans Cannot withdraw from a LIRA Must first convert to a LIF or LRIF Have minimum AND maximum withdrawal limits Locked in RRSPs (LIRA, LIF, LRIF) Once income is needed, consider withdrawing maximum Tax impact at you METR? Dave and Lisa? Use older spouse s age when converting to a LIF, LRIF Establish higher minimum and maximum withdrawal amounts TFSA Maximize contributions as long as possible Even during retirement (current tax savings + estate preservation) Can contribute in kind (gains triggered/losses denied) Contribution room is cumulative & includes withdrawals No attribution on withdrawals (unlike RRSPs) Fund TFSAs for spouse and adult children 21

Asset Location INVESTMENT ACCOUNTS Types & Features FRAMEWORK How to Allocate Funds FRAMEWORK Where to Put Investments PLANNING TIPS By Account Dave & Lisa want to know How to allocate $45K this year Invest or pay down mortgage? 1 4 Spousal RRSP? Which accounts? (RRSP, RESP, TFSA, etc.) 2 5 What should Lisa do with her locked in RRSP? Which investments in which accounts? 3 6 Hold assets jointly? 7 When should they convert their RRSPs to RRIFs? Know what you own and why you own it. Peter Lynch and where you own it! 22

Thank you! Questions? The information contained herein is for general information purposes only and is not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Many factors unknown to Odlum Brown Limited may affect the applicability of any matter discussed herein to your particular circumstances. You should consult directly with your financial advisor before acting on any matter discussed herein. Individual situations may vary. 23