Category Archives: Investing

ETFs and RRSPs

I sometimes take it for granted you the reader understand the alphabet soup of abbreviations that I use on this blog and while I do try to remember to define them in most posts I know I fail to do that once in a while.

So today I’m going to go discuss the basics of how we use Exchange Traded Funds (ETF) in our Registered Retirement Savings Plans(RRSP).  But before we dig into the specifics I should do a quick over view of what those both are.

First the RRSP is just an type of investing account. The RRSP is basically a glass you can put different investments into such as bonds, stocks, mutual funds or just cash as a savings deposit.  So you don’t buy an RRSP, instead you buy an investment to put in an RRSP.

The RRSP account is nice because of two main features: it gives you a tax refund and it allows your money to grow tax free.  The first point most people understand in basic terms. You put money in an RRSP during the year and when you file your income tax return you let the government know about that deduction and they give you a refund on your taxes for the amount contributed.  In short, if you put in $1000 into an RRSP the government pretends you earned $1000 less that year and gives you back the income tax you paid on that $1000.  The rate they use is the rate you paid on your last dollar of income (other wise know as your marginal rate).  If you are not sure what your rate is look it up on these tables.   After the money is inside the RRSP account it then grows tax free while in there, but that is a bit of catch with RRSPs that few people understand when it come to taking the money out.  When you pull the money out of the RRSP you then owe income tax on that money.  Why? Basically when the RRSP allows you to defer income tax to a later time (it doesn’t let you avoid it) which is why they give you the tax refund after you put money in.

A quick aside, the Tax Free Saving Account (TFSA) is similar to an RRSP in the respect the money grows tax free.  The big difference is there is no tax refund on a TFSA contribution because you don’t pay income tax when you take the money out.  You don’t defer the income tax because you already paid that before you put the money inside the TFSA.

Now putting that aside, what the hell is the ETF?  Basically an ETF is exactly as the name implies it is an Exchanged Traded Fund, which doesn’t make a lot of sense to most people. So in short form I tell people image a company stock and an index mutual fund had a baby, the results would be a ETF.  A lot of ETFs are index based mutual funds that happened to be traded on the stock exchange like a stock.  So they have a ticker symbol assigned to them and you can buy them via any self directed investment account either at a bank or a discount broker and you pay a transaction fee to do so.  Of course you pay that fee each time you buy some or sell some of the ETF.

So why are ETFs things so great?  In two words: low fees.  I mean like VERY low in some cases.  I think most Canadians understand we pay some high mutual fund management fees.  Over 2% per year is common.   While Vanguard’s Canadian Index (symbol VCN) management fee is a mere 0.06%.  No that isn’t a typo.  Yes some ETFs are higher and around 0.25% but that is still a LOT less than than 2% or higher.  So by keeping your fund fees very low you end up with more money in your accounts each year and they grow faster than a typical mutual fund.  The downside is the transaction fees to buy the ETF.  So often people suggest you wait to change over to ETF investing until you have $25,000 to $50,000 to invest in total so your transaction fees costs don’t exceed your savings on your lower management fees.  The amount you need depends somewhat how often you contribute to the account (if only once a year you can get away with the lower amount).

ETF also come in fixed income types so it is entirely possible to have your entire portfolio in ETF with rock bottom fees which is exactly what my wife and I did with our RRSP accounts.  Our portfolios are dead simple and only consist of four funds.  One for the Canadian stock market, one for the US stock market, one for international stocks and finally one for fixed income.  We aim for 40% fixed with 20% in each of the other funds.  So overall more of our money stays in our self directed accounts due to low fees and they allows them to grow a bit faster than most people.

So I hope that helps explain a bit more of how our RRSPs work with ETFs.  Let me know if you have any questions.

How to Build a $100K TFSA

Okay by popular request I’m going to dive a bit deeper into how on I managed to build my TFSA to almost $100K balance since I started it back in 2009 despite only contributing $57,500. My annual return has been 10.5% since 2012 (I would have to dig in my archive to pull out the earlier years but you get the idea).

Honestly the first thing you should do to get an high TFSA balance is to use your full contribution limit each and every year as soon as possible.  Letting the contribution room build up is like letting dust bunnies grow behind your furniture.  It doesn’t help anyone.  If you don’t use it it won’t have compounding growth which keeps the balance growing.

You also have to decide what exactly your TFSA is going to be for your overall financial plan.  You can use it to park your emergency savings but that will result in your having less growth.  In my case, both my wife and I decided that the TFSA would be for income purposes.  We wanted to generate a steady stream of income from our accounts to help fund our retirement.  So while it grew fairly quickly since 2009 we do expect it to slow down going forward as we start to take money out of the accounts.

Now the third key thing to is to accept that if you want a big balance you are going to have to take some risks.  Using your TFSA as a high interest savings account or GICs is dooming your balance to stay low.  There is nothing wrong with those investments depending on your objectives for your money just don’t be so conservative that you are losing to inflation each year.  As I mentioned above our objective was income so we started off with individual stocks of dividend paying companies.

To find the companies that we would end up investing in we looked at our own bills we paid each month and bought in similar sectors.  After all monthly bills often mean long term clients that pay regularly into the business which gives the company cash to pay out dividends.  So we ended up looking at banking, insurance, telecommunications, utilities,  oil and gas, and real estate income trusts.  We then looked to have at least two different companies for each sector we invested in as we didn’t want to have all our eggs in one basket.  Also we tend to look towards higher yield companies as we planned the TFSAs as our highest risk accounts so we expected to be compensated for that risk (we typically looked at companies with about a 5% or higher yield).  Please note yield for a stock is just the dividend payout annually divided by the share price shown in percentage.  A high yield can be the result from a company having a period of bad news that temporarily drives down the share price.

Once we identified a potential company in a sector by yield we would then pull open its last annual report and flip to its asset and debt balance sheet and look for its retained earnings.  A good value here usually indicates the company is sitting on some cash so in event of a downturn in their business they can keep paying their dividend.  If the retained earnings were low and the debt levels were high we would often avoid buying the company.  Also at this time we would take a look at how long has the company been paying a dividend and how often they increase it.  Steady dividend growth often means a decent growth in the company overall which is good for the share price in the long term (and your TFSA balance if you buy shares in the company).

Later on we added an ETF of preferred shares to our TFSAs instead of bonds to give a bit more balance to the risk profile of the accounts but still focus on producing income.

Then the last factor in getting a high TFSA balance is: luck.  You occasionally will pick a company that does REALLY well the spikes your balance.  For me it was AQN (Algonquin Power & Utilities Corp) which I managed to buy when it was under a cloud of doubt due its debt level but the overall numbers looked fairly good and utilities have very dependable cash flows. My yield based on my purchase price is somewhere above 10% now.  For my wife, she bought MFC (Manulife Financial Corp) and the share priced increased by around 30%.  So yes, that is hard to predict but it does occasionally happen.

So what do you use your TFSA for and are you happy with your return?

The Oddity of Inheritance

As some of you may know from my various posts over the years that I haven’t included any inheritance in my early retirement plans except as a back up plan. Why? Well on the surface a windfall of money later on in your life could be very helpful for your funding your own retirement but it sucks from a planning perspective.

Why? Well in short you can’t control the amount of money you will end up with and you also have no control on when you might ever get it.  So both of those uncertainties makes an inheritance nearly useless for you to be able to depend on for planning your retirement. As an example for discussion let’s say I may end up inheriting $100,000 when I turn 50 or $25,000 when I turn 60. In either case that would have vastly different effects on the math of your withdrawal rates (if you feel so inclined you can play with your own retirement numbers to see what I mean).  Yet you really can’t know when or how much you will end up with the inheritance as there are too many variables involved.   So in short I really don’t recommended including it at all when you are doing your planning for your early retirement.

Yet now we have a bit of an oddity. Depending on how good your own parents or your spouses parents are with money you might end up with a significant amount of money one day out of the blue.  After all a $100,000 dollars (or what ever amount you get) is nice regardless of when you get it. But what should you do with it if you are already financially independent and don’t need the money for day to day expenses. Now there is two main options that spring to mind: enjoy the money or use it for the next generation.

The first option of enjoying it is, of course, the easiest. You can invest the money and use the extra funds to take a few extra trips or do a renovation on your house because you want to. In effect it becomes fun money to do what every you like.

The second option of using the money for the next generation also has interesting potential because if you invest the money and you can either hand it over in lump sums at key points in their lives or gift the entire portfolio to them when you feel they are ready for it. This has some significant advantages depending on the amount of money per child.  For example, they could graduate post secondary with no debt and have some seed money to have them save towards a house down payment. Or you can boost your own children’s retirement savings when they are young they could give them a leg up on working towards being financially independent or using it to fund their own business or further their education or what ever you deem important.

Or another option, if you prefer, is you can save the money and play the really long game of investing your your actual or future grandchildren’s education and seed money for their retirement savings.  Thus building the capacity of your family line to continue to be ahead of the curve of most people when it comes to student debt and retirement savings.  The major problem of planning this long game is there is no guarantees that your grandchildren will continue the tradition to their kids.

For me personally I sort of hate to choose and might end up doing a bit of everything.  It all depends on the circumstances of how old I am and where my kids are at in their lives when my parents die (not that I’m looking forward to this but as I turned 40 this year I’m aware it will happen at some point regardless of when I’m ready for it).

So have you given any thoughts to your legacy?  What would you like to see your children do with their inheritance? Or what would you do if you received an inheritance?