UK Stakeholder Child Trust Funds

Every child living in the UK (with some exclusions) has the right to a Child Trust Fund (CTF) and the Stakeholder is the standard type of CTF that every financial services provider must offer to the public if it wants to offer any CTF. The list of approved providers has no less than 44 companies. The providers includes a wide range of institutions from banks to building societies to credit unions to stockbrokers to fund companies. In addition, there is a list of 73 distributors who work with providers and pass along applicants, no doubt garnering a share of the fees in the process. That list is even more varied from banks again to retailers like Boots and Asda.

One might think that there would be a bewildering variety of Stakeholder plans with so many options, tweaks and special conditions that it would be impossible to compare. Not so! In fact, as it turns out, for a Stakeholder type of account, there is little need to compare. One is pretty safe to simply go to whatever institution or store one finds most convenient. That's due to several reasons:

• first, the government has imposed certain terms and conditions that every Stakeholder plan must respect, like a cap on annual fees of 1.5%, no upfront charges or commissions, no charges/commissions on additional investments, no exit fees, no switching fees, acceptance of additional lump-sum or monthly investments as low as £10; this eliminates almost all of the nit-picky but often important detail differences between providers and their products that drives one crazy trying to compare - hooray!
• second, it seems that the majority of providers have opted to offer (only) a UK FTSE index tracking fund for their Stakeholder accounts; some use Legal and General's FTSE All-Share Tracker, some the Insight Investment or the Homeowners versions thereof while F&C use their own; the providers that differ provide a balanced fund of about half equities vs fixed income/gilts; though I prefer the all equities option due to the 18-year long investment time horizon (the child only receives the funds at their 18th birthday, so there is time to even out the highs and lows of stock markets and gain the historically greater returns of stocks over fixed income), either type of plan is ok; the nature of the underlying investment, whether equity index tracker or balanced fund is probably the only question that needs to be asked I believe.
• third, the cap on fees at 1.5% means that all the providers, are you ready, have exactly 1.5% annual fee - no shopping around required! While this may seem like cartel pricing, if one puts oneself in the shoes of the financial provider, there will likely be a lot of small accounts (the government contributes only £250 at birth and another £250 at age 7) and a lot of ordinary folk who need much handholding at extra cost, so there likely isn't a huge profit being made. I'm guessing this is also the reason those cheaper-to-administer index tracking funds are the standard investment vehicle ... but that's a good thing compared to actively-managed funds, which as we all know will, on average, under-perform the index. The only exception I found to the 1.5% annual fee, out of about ten funds I checked into, was the F&C offering of their own FTSE All-Share Tracker at 1.22% annually - go for it!

So there you are, stick your child's money and anything else you can spare - best, just set up an automatic debit from an account into the CTF (another capability that is mandatory for all Stakeholder accounts) - then forget about it for 18 years while you get on with life.

Actually, that's not quite the best approach. When the account balance gets to about £1100, it is worth looking to switch to a non-Stakeholder Share dealing account. These types of accounts allow any sorts of fees, conditions and investments, which one chooses oneself, so a lot of shopping around and nit-picky comparison is required. Though I did not check out all the 13 approved providers (listed here) of this type of account, an interesting one I came across is offered by The Share Centre, which allows one to buy the Legal & General UK Index Tracker at no upfront charge at a mere £10 or more per contribution and the annual fee amounts to about 1.03% (0.125% quarterly admin fee plus 0.53% Legal and General annual management fee). That's an assured risk-free increase in annual return of almost half a percent - £4.70 per year per £1000. It more or less pays for the Share Centre admin fee.

Saving for Children in the UK Compared to Canada

It has been an eye-opener the last few days doing research for some of my Scottish relatives into the Child Trust Fund program (CTF) that exists here in the UK and comparing it to the closest Canadian equivalent, the Registered Education Savings Plan (RESP). The UK government created the CTF only in 2005 - one wonders whether the policy makers took a look at the RESP and decided to simplify and improve it.

The key common point is that both the CTF and the RESP are tax-protected savings accounts for the future of children. Both also enable savings into various types of equity holdings (stocks, funds, ETFs) and fixed income (bonds, bond funds, guaranteed savings). And both receive some direct contribution of funds from the government.

But the differences between the programs abound:

• RESP is intended to be used only for higher education (and tax-exempted accordingly) while the CTF can be used for anything; score one point for the CTF
  
• CTF receives from the UK government only £250 at birth of the child and another £250 at age seven, while the CESG from the Canadian government to the RESP can be up to $400 per year, soon to be $500 according to the March 19 budget (though the lifetime limit remains at $7200); score one for the RESP
• CTF annual contribution limit is £1200 (about $2700 at today's exchange rate) while the RESP's is $4000, a cap that the budget also eliminates; score one for the RESP
• CTF ends at age 18 but RESP can exist gaining tax-exempt income till age 25; score one for the RESP
• CTF assigns ownership to the child from the beginning and the money is locked into the account (except for terminal illness, in which case funds can be used early) till 18, but the RESP doesn't prevent early withdrawal, a flexibility advantage, though the effect of CESG needs to be considered (see HRDC website); debatable which is better, score it even.
  
• CTF on maturity passes directly to the child to do whatever he/she wants while the RESP is still controlled by the Plan holder (most likely a parent); here's a good debating point! should an 18 year-old be put in full control of a potentially large sum to do whatever with, no accountability to anyone required? my view, with my limited experience of my own kids is, they learn to do it, just like they learn to pick up after themselves when they move into their own place; score one for the CTF
• CTF withdrawal is simple and straightforward while RESP is complex and time-consuming with bad consequences if done the wrong way (all that keeping track of CESG vs capital contributions vs income and the proper withdrawal sequence ... ouch it's a bureaucratic nightmare); score one for the CTF
  
• CTF has three sorts of mandated account types (see the first CTF link above for details) that allow easy choice amongst them according to risk preferences and easy comparison within an account type while the RESP multiplicity of investment vehicles is complex and time-consuming to figure out (to see what I mean check out this discussion on MillionDollarJourney's blog); the UK government has succeeded in establishing a level playing field for the CTF that seems to meet general approval, including mine, which counts the most of course ;-) score one for the CTF
• CTF's account-fee cap of 1.5% on the Stakeholder account type, which minimizes profit prospects for providers, has oriented them to offer index-tracking equity funds rather than actively managed funds, which are more likely to under-perform the index; score one for CTF
• CTF and and Human Resources Development Canada (HRDC) both provide listings of approved providers of the respective plans but CTF shows the types of plans of each provider and gives some guidance on how to choose; score one for CTF
• CTF lowest cost self-directed provider of an index tracker fund that I found at the Share Centre comes at about 1.03% total annual fees while for an RESP there is TD CanadaTrust's eSeries which vary from 0.33% for the Canadian Index to 0.48% for the US currency hedged (S&P500) Index or the International MSCI EAFE Index; too bad a CTF holding has to be traded on a UK exchange!; on top of that, there's only fund as cheap here in the UK so one cannot diversify beyond the UK FTSE index; score two for the RESP
  
• UK telephone helplines of both regulators and providers of CTFs are answered quickly
  (within seconds generally) by knowledgeable personnel without going through menu trees and such, while in Canada one can easily wait for minutes (it was about 10 minutes for TD CanadaTrust) or reach only an answering machine; score one for the UK
  

Overall, the RESP seems better for people like me (because my kids have gone on to university) than the UK's CTF, but what a hassle compared to the UK!

Asset Allocation - What's That and Why Should We Care?

Finance research says that 90+% of portfolio return is attributable to asset allocation. Wikipedia has a useful entry on asset allocation that outlines some of the studies and issues. What does that mean in terms of what I should do as an investor?

The first step is to define terms. What is an asset? Almost every source skirts the issue and immediately begins discussing stocks and bonds as if the answer is self-evident. This makes me suspicious. Defining beauty as being in the eye of the beholder is fine for endeavours where judgement and qualitative judgements are acceptable but this is not the case in finance where fact-based reasoning is the basis for good decisions (though perhaps not the complete answer). One place that provides a definition of asset is Duke University finance prof Campbell Harvey's website. His definition is short and simple: "Any possession that has value in an exchange." The definition for exchange says that means places like the NYSE, NASDAQ, which trade stocks, bonds, commodities and indexes. In turn, therefore, the implication is that it is only those types of possessions that can be considered assets. Isn't this definition too restrictive? One enormously important possession which constitutes a considerable part of most individual investor's net worth, myself included, is my house. Many have cottages too. Then there are other kinds of possessions that many consider to be investments, such as fine art, antiques, coins, rare wines, even hockey memorabilia. At one time long ago, I believe tulip bulbs were a popular investment asset!

I suspect that such a restrictive definition, implicit in many investing tools, websites, books etc, where the choices discussed are limited to stocks and bonds, arises for a couple of reasons: first, availability of data that can be directly comparable and computed into portfolios in a risk-return relationship; second, the comfort zone and asset area familiarity of the advice giver, or maybe, to look at it more cynically, what the advice giver has to sell. Yet, out here in the real world, we individual investors deal with everything tangible and intangible that we can buy and sell. Such a broader definition of asset is provided by various sources such as Answers.com: "A resource having economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit." In real life, we ask ourselves whether it is better financially to buy a cottage or invest in the stock market, so we need a financial structure to do that, recognizing of course, that not all such investment decisions are purely financial matters. The onus is on those who would exclude the broadest possible definition of asset.

I believe there is a critically important positive reason to factor in a broad range of assets and that has to do with risk reduction and diversification. Diversification only works in reducing risk if the various investments do not move in tandem. In technical terms, moving in tandem is expressed as a correlation coefficient, a statistical measure that moves between +1 and -1. At +1, two investments move exactly together all the time. There is no risk reduction at all from combining such assets. With 0 (zero) correlation, they do not move at all together but in random fashion relative to each other. The other extreme of -1 correlation is when one moves up, the other moves down. This is, in fact, the best situation since risk can almost entirely be eliminated. (It does not mean however, that there are no overall returns - that the negative return cancels out the positive and the investor is left with no net gain.) A very good explanation of how this works with simple examples to illustrate what I've just said is here at the website of TIAA-CREF.

So, the principle I draw from all the above is that assets and the choice of assets need to be defined functionally in terms of correlations amongst each other in anticipation of being combined into a portfolio with the highest return for the least risk. And to adopt a broad definition of portfolio, I think the appropriate definition is the combination of everything I own that can be sold, not just those pieces that sit in my brokerage account.

This isn't the end of the story on asset allocation. Next, for a future post, is the question of which assets have which type of correlation.

iShares Distribution Reinvestment vs DRIP

A follow-on to yesterday's post about Exchange Traded Funds (ETFs) is another perhaps confusing characteristic regarding distributions and reinvestments. As the blue highlighted area of this table shows for the Canadian iShares ETFs, in 2006 there were both cash distributions and reinvested distributions paid on a number of the ETFs. The cash distributions are actually paid out to the owners of each ETF at the end of each quarter just like dividends of any other company stock (with shareholders of record date for eligibility etc). An iShares press release gives the amounts for the 2007 March end quarter. For buy and hold investors like me, I don't need the cash/dividend to pay everyday expenses and I would rather that all the money be reinvested with the least cost and effort. Unlike many companies which have Dividend Reinvestment Programs (DRIP) that allow any dividends paid out to be automatically used to buy extra shares without brokerage fees, iShares cannot do so itself with its cash distributions as it explains on this FAQ page, though it says that brokers might provide the service (and it seems that Canadian ShareOwner Investment Inc is one that will but mine - BMO Investorline - will not ... hint, hint).

Stingy Investor has a very handy page listing all the Canadian companies with DRIPs (and related things like Stock Purchase Plans) for those who are interested.

Excellent Personal Financial Planning Primer

The Financial Webring is already bookmarked on the right hand side of this blog as a discussion forum but I've discovered it also has a fine brief primer on personal financial planning. The advice is direct, understandable and sensible. It covers all the main areas one needs to be concerned with, namely:

• Day to day finances (budgeting, expense control, mortgages, other debt, emergency funds, etc.)
  
• Insurance (life, health, disability, property)
  
• Taxes (exemptions, deferrals, income splitting)
  
• Investments (asset allocation, security selection, risk management)
  
• Retirement (pensions, RRSPs, RRIFs, annuities, etc.)
  
• Estate (wills, powers of attorney, use of trusts, planned giving, etc.)

There are very useful links to further reading. Like everyone, there are areas in which I am fairly knowledgeable and others where I can use some improvement so the page is a good launching point for further investigation into those weak areas.

Adjusted Cost Base for ETFs and Mutual Funds

I'm doing my taxes these days and part of that is to report the gain on some iShares Exchange Traded Funds (ETFs) that I sold in 2006. There's a tricky bit involved in that process which I figure is worth noting in case anyone might end up paying tax twice on their gains. Though mutual funds and ETFs are substantially similar in that they pass through capital gains and income to unit owners, there is a particular and important difference when it comes to the reinvestment of distributions. In mutual funds, the reinvestments show up as additional units and a higher adjusted cost base (ACB) for those units but with ETFs they do not. You must keep track yourself of the reinvestments and the higher ACB for ETFs. Otherwise, if you just take your original purchase cost for the ETF as the ACB, you will end paying tax again on the reinvested distribution that you already pay each year when taking figures from the T slips. I know my discount broker BMO Investorline does not keep track of the higher ACB when it shows my cost in account listings or statements. Probably none of the discount brokers do and I'm not sure all full service brokers do. It's worth checking. The iShares website has a good FAQ on the subject with more detail and a side-by-side example of the ETF vs mutual fund method. Here is another good explanation how this works for mutual funds from McColl Turner Chartered Accountants. Update January 14, 2008: Note that a return of capital distribution reduces the cost of an ETF and it is necessary for an individual investor to subtract it to properly track ACB. The proper formula for ACB, as explained by Howard Atkinson on page 160 of his excellent book on ETFs, The New Investment Frontier III, is: ACB = (total purchases + acquisition costs + reinvested distributions - return of capital) / units purchased. The main iShares page has a link labeled iShares CDN Funds - 2006 Tax Characteristics which shows all the iShares Canadian ETFs and their reinvested distributions; for earlier year breakdowns, go into the individual fund info and look for the Distribution History link on the left hand side e.g. this page for the Energy sector XEG fund.

I have to admit that despite my general preference for ETFs, this is an advantage of mutual funds over ETFs in the calculation convenience and the avoidance of costly oversights. Over a long holding period this can be significant. Even in the short space of two years from 2004 to 2006, the iShares TSX 60 XIU that I sold increased by almost $3 per unit in ACB. I'd be paying our friends at CRA quite a bit more if I simply used the original purchase cost.

Book Review: Buying Time by Daryl Diamond

The "buying time" title refers to spending more money early in retirement to have fun and not end up with a big pile of money kept aside for fear of running out with regrets for all the things that never got done in retirement. The subtitle of this book describes better what it is about: "Trading your savings for income and lifestyle in your prime retirement years". The author is a professional retirement planner with his own website.

This book has great value in that there are few if any books (or info on the web it seems) that take an integrated, holistic view of retirement financial planning to show how the whole process starts with lifestyle priorities that then drive a number of complementary financial components and actions. There are many books or websites from which one can obtain precise and comprehensive information and guidance on individual elements such as RRSPs/RRIFs, insurance or annuities but none that put it all together. The book covers all the acronyms and keywords at various degrees of depth: RRSP, locked-in RRSP, RRIF, LIF, LRIF, CPP, OAS, pensions, insurance, annuities, probate, wills. estates, trusts, power of attorney, capital gains, dividends, interest, bonds, equities.

I found very useful Diamond's discussion of the critical lifestyle priorities, namely providing sufficient income throughout retirement (i.e. making sure not to run out money), especially considering major health care requirements for critical illness and long term care, and whatever desire there is to pass along wealth to family or friends (i.e. not the taxman). It was also very helpful to read the explanations of insurance and annuities, something I have not yet spent much time learning the ins and outs of.

The book's stated objective to provide introductory, conceptual level treatment is also, for the DIY person, a major limitation. Diamond's constant refrain is: "to work out an actual detailed plan, go see a financial planner". Is it really beyond the capabilities of an interested, reasonably intelligent person who takes the trouble to buy and read such a book, to go ahead on his/her own?

The other important caveat is that the book needs a major quality improvement overhaul and significant updates. Diamond may be a good financial planner but he needs the services of a good editor to improve grammar, sentence construction, explanations, organization/story line, labeling and such. Many times I found myself saying to myself that something was incorrect, only to think about it and figure out that it was just the awkward explanation. The update is needed for important changes that have occurred since the 2003 publication date: new tax rates for dividends, tax brackets, foreign content rules for registered accounts, RRSP maturity (in the brand new federal government budget) and the introduction of variable payout annuities, which are not mentioned at all (and which annuity authority Moshe Milevsky termed a development which has "... the potential to revolutionize retirement financing in Canada." in his paper How to Completely Avoid Outliving Your Money (about which I wrote a post a few weeks ago).

A pet peeve of mine is the short shrift he gives to Exchange Traded Funds, exactly 11 lines of text, while the whole body of his discussion assumes the use of mutual funds for equity holdings.

Among the interesting but puzzling observations Diamond makes is that the first ten years of retirement are the best ones. Now it makes sense that declining health will limit activities as one gets older. But what if I decide to retire in my mid 50s? Does it mean I will be worse off after 65 compared to someone who retires at 65 and begins to enjoy his ten best years? And in financial terms, will I need less from 65 on than someone who starts his retirement at 65?

It would be very beneficial for the updated revise edition to include four or five annotated case studies of a complete financial plan. Certain themes and situations must arise often enough to be relevant to a large portion of the public. With all his experience, Diamond would surely be able to identify them.

In sum, this is a useful but by no means definitive book on the subject of personal financial management in retirement.

Free Money at Renasant Financial?

A friend noted that today March 20th the shares of Renasant Financial Partners Ltd (TSX: REN) were trading around the $2 mark and wondered if it would be possible to get the $3 per share special distribution the company will be making on March 30th per this press release. Not a bad deal if it were so. But the press release states that the $3 would go to shareholders of record on March 22nd. Therein lies the rub and the explanation why it isn't possible to buy a share for $2 to get the $3 cash. It is simply that the shares are trading "ex-dividend" as of March 20th, that is, any shares bought on March 20th will NOT receive the distribution, which is a return of capital and not a dividend. The reason the payment is not included is that shares in Canada, as in the US, have three business days to settle and to appear on the company's records. Two days - March 20 to March 22 - doesn't make it. The Investopedia has a good explanation of how this works.

As a result, from March 19th to the 20th, the price of REN dropped by almost $3 ($2.92 to be exact). The chart from Yahoo shows this in operation, though it is a bit puzzling why the trades early in the day were around the $4 mark. Maybe some investors got confused about the ex-dividend status, or did they just think the remaining business minus the $3 payment was still worth only a buck less?

It's another illustration of the old adage "if it seems too good to be true, it probably is."

Book: The Intelligent Investor by Benjamin Graham

Reviewing this book is akin to judging Warren Buffett's stock picking prowess. In fact, it is so very directly, since Buffett was a student of Graham and states that he uses Graham's methods. The quote from Buffett on the cover says it all: "By far the best book on investing ever written." The proof is certainly in the pudding, as one learns that Graham himself was a tremendously successful investor. An appendix by Buffett details the phenomenal investing performance of a number of Graham disciples. The updates to 2003 by finance journalist Jason Zweig (Graham died in 1976) illustrate the timelessness of the book's investment principles by providing numerous examples from the Internet dot com bubble and frauds such as Enron and Worldcom. As well, Zweig repeats and amplifies Graham's points for anyone who may have missed the subtleties.

Apparently, the secret to success in investing is "don't lose". The book outlines in 600+ pages of detailed, practical advice, backed up with mountains of supporting data, how to put the odds on your side, avoid losing and make either reasonable/modest (the defensive, passive investor) or excellent gains (the enterprising, active investor). A key lesson is that unless one is willing to devote the time and energy into doing the investigation required, one should stick to a broadly diversified portfolio of bonds and stocks, such as buying the index directly like a portfolio of the Dow Jones stocks, Exchange Traded Funds and passive low cost index tracking funds.

Want to know how to actually carry out the famous "buy low, sell high" strategy, aka Value investing? Graham shows how to calculate when a stock is low (what current ratio, earnings per share, debt coverage etc - no vague waffling here!) and when it is too high. The trick is finding such companies and prices. Only problem for us investors is that this requires lots of never-ending work, there's no escaping it. That's for the enterprising investor. For the rest of us, the emphatic advice is, be a defensive investor who doesn't pretend to know where markets or particular stocks are going. Instead, we are told to put together a portfolio with both equities and bonds (no more or less than 75% in each) that is well diversified and regularly rebalanced (every six months according to Zweig).

Despite being replete with tables of numbers, footnotes on virtually every page, copious references, citations of academic research, appendices, there is not an oppressive feeling of density to the text and boredom does not descend. The writing flows very easily, the explanations are unambiguous and the presentation follows naturally and logically. There are constant juicy bits to copy and remember. e.g. "... the investor's chief problem - and even his worst enemy - is likely to be himself." or "... the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions." or "... the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future."

No doubt my copy will get many re-readings. Just wish I had bought it twenty years ago. Maybe this book should be made compulsory reading, with a test, before anyone is allowed to buy securities. ... on the other hand, because most people don't apply Graham's investment principles, as Warren Buffett says in the appendix, "There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd (referring to the more technical book written by Graham with David Dodd called Security Analysis) will continue to prosper."

Buy this book at
chapters.indigo.ca

UK Discount Brokers

The last task in the exercise to remodel the portfolio of a UK relative, described in yesterday's post, was to find an easy way and low cost way to purchase and administer the required new holdings of Exchange Traded Funds and OEICs. The list of factors I considered:

• account administration fees
• interest rate on cash balances as a minor factor due to the intended buy and hold strategy
  
• trading cost as a secondary factor since the intent is to buy and hold over the long term, and making purchases only to re-balance the portfolio once a year
• online trading and account access in a self-managed (no advice) relationship with the broker
  
• ability to hold ISAs, PEPs and regular with one company to simplify statements and facilitate transfers amongst accounts (since the move of investment funds into the tax-exempt ISA will take several years due to the annual £4000 contribution limit)
• account closure and transfer fees in case a change might be needed
• customer service - tested by phoning and asking for details; here there was a pronounced difference between the best and the worst (HSBC); another factor was the ease of finding info on their websites
  

In doing my investigation, all of it initiated through the Internet, one useful source for the traditional brokerage firms was the website of The Association of Private Client Investment Managers and Stockbrokers, which has a search / selection tool to narrow the list to brokers. However, it doesn't cover all possibilities - I discovered the Motley Fool and Etrade UK. Who knows there may be others.

The result came out in favour of Selftrade by a hair over E*trade and Motley Fool, which actually have lower trading fees of £8.95 and £10 per trade, respectively, vs Selftrade's £12.50. However, Selftrade has a single annual £25 account admin fee for any number of ISAs and PEPs, the lowest going and lower transfer out fees. Motley Fool pays nothing on cash balances and has higher transfer out fees while the killer for E*trade was poor customer service - being disconnected on one call, ring-no answer on another call and a long wait to finally get through on the third call. Selftrade phone answering was prompt, the phone triage menu tree short and the person who answered was knowledgable and patient. The big banks and brokerages like Barclays, Lloyds TSB and HSBC all were a bit more expensive on both trading and account admin fees.

If anyone has any experience, insights or other sources of info, your comments would be most welcome.

Remodeling a UK Equities Portfolio

For the past week, I've been pre-occupied in reviewing a UK relative's investments and it is a familiar story. This person is not at all interested in managing investments day to day but does want to save money in the long term. The result has been a hodge-podge of assets that are inefficient and poorly diversified despite owning a number of different funds. The chart on the left, taken from Trustnet, shows the various holdings. Despite the variety of names, all are essentially composed of UK equities and when one delves into the funds, one discovers the same major companies such as BP, HSBC, Royal Dutch Shell, and Barclays. The funds display the familiar under-performance relative to the index, the FTSE in this case, as four out of eight failed to beat the FTSE All Share gain of 44.3% over the past five years. For comparison, I added into the chart an index tracking fund - the M&G Index Tracker A Accumulation. As is typical of index funds, the M&G tracker also under-performs the index, gaining only 40.6% over the five years.

One thing that has surprised and disappointed me is the small number of Exchange Traded Funds available in the UK. iShares offers only a FTSE 100 (the 100 largest companies) and a FTSE 250 (the next largest companies after the 100) ETF but no FTSE All Shares tracker at all. Perhaps that is because the iShares ETFs are registered in Ireland and so do not qualify for dividends tax exemption when held within the tax-free ISA (similar to RRSP in Canada). That gap led me to search among the regular funds (called OEICs in the UK) for index trackers such as M&G's. Their management fees and expenses are thankfully not too high, as one would hope: M&G's comes in at 0.3% annually. It is interesting to note the uniform 1.5% management fee applied by all the other OEIC funds, no doubt as the result of adhering to the FSA's Stakeholder program whose aim is to ensure fair conditions for fund investors. In addition, the above returns do not account for the initial charge or front end load on the OEICs that vary from 4% to as much as 6.25%. To put it another way, making up the initial lower amount invested takes about five years at 1% return more per year. Can the winning funds continue to out-do the market or is it likely they will revert to the mean? All this is to say that I've suggested getting out of OEIC into market tracking funds.

The other major change is to suggest to my relative to take advantage of the ISA program under which one can contribute up to £7000 annually in a non-taxable account. Why was that tax advantage not used? It's just not knowing about it in this case.

There is a huge number of funds available in the UK and it is a big chore sorting through and comparing them. I found a number of useful sources like the website of the UK regulator, the Financial Services Authority, which has comparative tables for all types of investments and shows all the charges (why can we not have something similar from our Canadian regulators?). There is also the Trustnet website, for performance tables and charts that allows one to enter and track a portfolio with updated values.

The lack of diversification beyond the UK also needs to be corrected. Therefore, IUSA (iShares S&P500), IAPD (iShares Asia Pacific Dividend Plus), IEEM (iShares Emerging Markets) will be substituted for the UK holdings where these can be put either into ISAs or PEPs (another UK tax-free plan - it was the pre-cursor to the ISA and can still be held as a "grandfather" type of account). For regular taxable holdings, about a third of the total equities will still be in the UK but as the M&G FTSE All Shares Index Tracker. The last chunk will go into M&G European Index Tracker, a broad based OEIC fund with 0.5% annual fees and no initial charges.

It has been instructive to see how a typical passive investor can evolve a portfolio by accident that can be improved with such simple measures as better diversification, lower fee funds and use of tax-free accounts.

The next stage was to find a place to buy and hold these new assets, a big job in itself and worthy of a future post.

Lessons from an Expert on Annuities

Moshe Milevsky is one of leading experts, if not the leading expert, on retirement finances and annuities. A professor in Finance at York University, he has written a number of consumer advice books and many research articles. He also heads the non-profit, public-service Individual Finance and Insurance Decisions Centre.

I have just finished reading his paper on variable payout annuities, charmingly titled How to Avoid Completely Outliving Your Money, and would highly recommend this very readable paper to all those who like me are preparing to transition from the financial accumulation phase to the consumption phase, aka retirement.

Some of the bullet points of note in this paper:

• the value of annuities stems from the dispersal of the financial assets of the deceased amongst the survivors (but don't worry, or make nasty plans to bump off other annuitants, your benefits don't go up or down if people die sooner than expected ;-)
  
• the longer you wait to buy an annuity, the more you will get per month
• people who purchase annuities live longer than the population average; no, buying an annuity doesn't cause you to live longer, it's just those who do purchase them are healthier and wealthier than average and these people do have a tendency to live longer (PS insurance companies know this and price it in)
  
• fixed payout annuities are very vulnerable to inflation, just like bonds; even at 2% annual inflation, there would be a 1/3 loss in purchasing power after 20 years; at 4% inflation it's down by more than half; the following words, written in 2002, are still true today "in today’s close-to-zero inflation environment, surprises can only be in one direction"; of course, insurance companies do offer fully or partially inflation-indexed annuities.
• annuity quotes vary considerably among financial institutions so it is important to shop around
  
• the greater your estate creation of bequest motives, the lesser should be your interest in annuities
  
• with variable payout annuities the optimal age to annuitize is much earlier - about ten years; Milevsky shows one scenario in which the optimum age to buy an annuity for a single woman is 80 years old for a fixed annuity but 70 years old for a variable annuity; for a single man the same fixed vs variable annuity optimum is 70 years old vs 60. Milevsky points out these ages would change for different individuals
  
• variable payout annuities enable one to construct an underlying portfolio of stocks and bonds that funds part of the annuity payment; this better matches financial theory that states one should be diversified between these asset classes and not just dependent on fixed rate / bond-type investments as is the case for a fixed annuity.
• variable payout annuities also allow one to shift the payout proportion to either earlier or later years in retirement e.g. this can suit those who anticipate they will be more active and want to spend more early in their retirement and to tail off later on ... in fact, don't the round-the-world tours tend to diminish once people hit their 80s?
• the greater the emphasis on consumption versus bequest motives, the greater the role of payout annuities in the optimal retirement portfolio

The IFID website has many other research and popular press articles on annuities. More to relish reading!

The More You Learn, the Less You Know

One of the pleasures of handling one's own investments and finances is the continual learning and the intellectual challenges that come from really understanding how various products work and especially the background theory, since that is what enables going beyond rote advice or partial, non-integrated solutions. However, it is a big challenge that just seems to grow as I learn more! Long ago, I learned the differences between common and preferred shares, bonds and treasury bills, ETFs and mutual funds. Many years ago, I did an MBA in Finance at the best (at the time, is it still? can you guess which one?) school for finance in Canada, and learned how to derive the CAPM and the Black-Scholes option pricing formula. Later I successfully passed the Canadian Securities Institute course. Yet as I write this blog, it seems the new stuff I need to know, both theoretical and practical, is growing without limit! On top of that, to actually manage my financial affairs, taking in the huge volume of news and data spewing forth each second could occupy every waking hour.

And yet, decisions must be taken and investments made. Tempus fugit. In the words of Scotland's bard Rabbie Burns (not Robbie!! though Robert is acceptable, as I have been reminded numerous times by Scots), "Nae man can tether time or tide". I suspect that's why so many people who have less interest and time to spend on this stuff can get taken in by idiots and crooks. Or, they succumb to the bane of too many DIY investors, shortcut the investigation process, going with their instinct or changing their approach every other day, depending on what they read last. Oh well, isn't the beginning of enlightenment the recognition of one's own ignorance?

Canada's High-Taxes vs the UK

When I decided to come over to Scotland, I investigated the tax consequences, expecting to find myself paying more tax over here in the UK. I was surprised to find the opposite, in fact, quite the opposite. For my fellow Canadians out there, here's the shocking news - the excess rate of taxation is considerable and across the board in all types of income and investment taxes.

Refer to the chart for all the numbers. I've used Ontario as my benchmark province.
The UK advantages start with the personal exemption of about $11,500 vs only $8839 in Canada. Take your marginal tax rate and compute the savings on the difference.

On income and interest, treated as the same in Canada but taxed at a slightly lower rate on interest in the UK, the Canadian rate is higher in every single tax bracket and the difference is the worst for middle income earners. For example, in the blue highlighted line for taxable income in the $60k range the Canadian marginal rate is 33% vs 22% in the UK. Ka-ching, another difference that could reach into the four figures.

On dividends, the UK has a zero effective rate due to an offsetting dividend tax credit until a person has more than about $76,000 taxable income.

On capital gains, the rate is actually higher in the UK throughout the tax brackets but everyone is given an annual exemption of about $20,150 in net gains. That should suffice to ensure a tax-free existence for most investors of modest means.

Not shown in the chart are the comparable retirement savings vehicles, the RRSP in Canada and the Individual Savings Account (ISA) in the UK. An ISA offers the same tax-free accumulation/compounding as the RRSP. An ISA does not allow a tax deduction as does the RRSP. Instead, any withdrawals are tax-free as opposed to the RRSP where withdrawals are taxed at the rate for marginal income. The RRSP advantage of saving taxes by withdrawing after retirement when one's tax rate would be less is not there for the ISA ... but the UK tax rates are lower in the first place and more uniform up to high levels. In addition, the ISA doesn't create artificial incentives to keep interest bearing securities inside the RRSP and dividend or growth investments outside. For anyone who has struggled with portfolio balancing across both RRSP /LIRAs and regular accounts while minimizing taxes, this ISA feature would be a big boon. Perhaps the biggest plus of the ISA is that the £7,000 annual allocation that is not reduced by contributions to a regular pension plan and thus allows a much high tax-free savings rate if desired.


Though such differences are and were not the motivation for my move to the UK, nor would I advocate moving to another country just to save taxes, it does lead one to ask those people who make our taxes why they are so high.

Key Decisions that Affect Future Wealth

While we often focus on the stock market and our investment decisions as those that will most affect our future wealth, as I look back and around me, it seems that two other decisions we make during our lives have far more influence. I note in advance, to avoid getting into trouble at home, that neither of these decisions should be made exclusively or even primarily as financial decisions. It is true however that they both inevitably have a very large lifelong financial impact. My comments are descriptive, not prescriptive!!!

1. Career Choice - over a lifetime, the difference in income between a Zeller's cashier and a dentist adds up to quite a lot. Without going into the details of which career pays best, suffice it to look at the simple arithmetic of a lifetime of earnings, which has conveniently been made into a neat table by the Fiscal Agents website. Of course, choosing a career simply for the pay is likely to lead to stress, burnout and eventual abandonment. On the other hand, you get the opposite when your make a good choice - fun and fulfillment, which I would maintain is a non-financial form of wealth.
2. Spouse - pick the wrong person and you can have years, maybe a lifetime of misery, financial and otherwise. Think of divorce, its causes and its consequences. Pick the right person and it's the opposite - a lifetime of emotional happiness, of course, but this spills over into financial success. Not that the spouse brings a pile of money into the marriage but the support from a trusted advisor to not waste, to spend wisely, to invest wisely whatever money is earned makes a huge difference. Investing one's time, effort, love and attention in a marriage brings a very high rate of return. And a stock holding is just a number on a printed sheet, not very huggable. ;-)

In my case, the spouse element has been predominant in whatever financial success I have achieved. Would be interested to hear anyone else's views.

Taxes on Interest vs Dividends vs Capital Gains

A friend asked about how dividend taxation works and the difference in tax rates between the different types of investment revenue - interest vs dividends vs capital gains. He tried unsuccessfully to figure out the answer browsing through the Canada Revenue Agency's comprehensive but daunting website. Since he, being a smart guy, did not succeed, I figure this is worth a post for someone else's benefit.

I must acknowledge the excellent free Taxtips website, already linked under the Resources sidebar of this blog, for providing the calculators and information that produced the following results, though of course, if I've made any errors of interpretation that's not their fault.

The tax calculation of Canadian dividends goes through a grossing up process of the actual dividends we receive by cheque. Currently, this means adding 45% on top of the actual dividend, and the new higher amount is included in our taxable income. Yikes, you may say, that will raise my taxes! But through a clever tax credit calculation on the amount, the CRA gives it back and we all end up better off. Better even than interest or capital gains. (I'm referring to the most common type of dividends, those paid by companies listed on stock exchanges such as the TSX. See this Taxtips page for the nitty gritty of what is in this category termed "eligible" dividends.)

Use the Taxtips calculator to do your own numbers for your own province. I used Ontario for me and my friend. For almost every tax bracket, dividends have the lowest marginal tax rate, better even than capital gains, which may surprise some. The dividends tax advantage against capital gains diminishes progressively as you go up in tax bracket, being about 1% in the $72k-118k brackets for 2006. In the very top bracket, over $118k, the tax rate is higher on dividends. However, both dividends and capital gains have a significantly lesser tax rate - half or less - than interest or ordinary income (like salary) at all taxable income levels. (See this Taxtips chart, which shows both 2006 and 2007 brackets and marginal rates for Ontario.) That's why we are constantly told to put our bonds, GICs, CSBs and the like into our tax-sheltered RRSP.

Hmm, those banks stocks and utilities look better and better.