Principal Residence as an Investment

I've recently come across some fascinating reading by York University professor Moshe Milevsky on the subject of residential real estate and personal financial risk. One of his many papers, titled Houset Allocation (yes, it is spelled with the "t"), which is available at IFID website newsletters, shows rates of return on Canadian residential real estate in 19 housing markets across the country for the 25 years ending in 2004 when the paper was written. The annual compound rates of return vary considerably - from a low of 2.74% in Edmonton to a high of 6.23% in Peterborough. Along with these are the measure of volatility, or risk, in each market, again with a wide range from 2.81% in Regina to 11.14% in Vancouver. These figures alone remind one that owning a house as an investment isn't necessarily the best, considering options which include stock markets like the TSX and the S&P 500. Would one have been better (if one had perfect knowledge of the future, of course, which we all do in retrospect ;-) having a house in Vancouver that returned 3.68% per year compounded for 25 years at 11.14% volatility, or 13.85% in the S&P 500 with 15.71% volatility or a higher 5.7% return with lower 6.23% volatility in Ottawa, where my house is?

How about the homeowner in Edmonton, facing the laggard market there for 25 years? He/she might even have thought that the tar sands would one day have to take off and cause the local house price boom that is now underway. Sitting there in 2004, how much longer should he/she wait? Maybe a job change or retirement would force a sale, preventing the gain from ever being achieved. Years ago, I bought a condo in Ottawa at the same price the original owner had paid five years earlier, then there was a bump in prices and I sold it for a 250% gain six years later, pure luck because I needed to move with my growing family into my larger house. That house bought 22 years ago, well maintained and in a good neighbourhood, has only appreciated 4.8%, i.e. below the Ottawa average. The long term can be a very long, one just doesn't know how long.

One of my relatives lost their whole investment in their house when the mill in their small town closed down and there were no buyers so they had to walk away from it. An individual asset risk of a specific house in a specific market is not a sure investment gain. That is a key point made by Mr. Milovesky in the above paper, namely that a house is a non-diversified investment. It is also likely a huge proportion of a family's total investment assets. It certainly is a big part of my net worth. If one were able to own several houses in different cities across Canada, the low correlation of price gains between the cities would allow a considerable reduction in risk. He even proposes that housing REITs be set up along the lines of commercial property REITs so that each of us could sell a part stake in our houses and buy someone else's. He says it's been done in the UK and Australia but not yet here in Canada.

As an asset class on the other hand, a house is quite un-correlated to stock markets. Ottawa residences were negatively correlated with both the TSX and the S&P 500 over his study period and so are good to hold in a portfolio. In any individual period, as opposed to the long term during which they both go up, when one goes down the other asset class goes up and this reduces risk.

Among the options Mr. Milevsky reviews for reducing housing risk for individual homeowners, only the reverse mortgage is currently available in Canada. Given the fixation of many people on the tax-free capital gain on a principal residence as being a kind of be-all, end-all justification for owning a house in Canada, the above certainly warrants some thought. I'm keeping my house but whenever the housing REIT comes along I'll be having a close look, and the reverse mortgage is a good option to know for the future too.

Online Sources - Mortgage, Annuity, Retirement

Just discovered a couple of interesting websites that may useful to others:
- https://www.cannex.com/canada/english/ in reality oriented to institutions and professionals but it has some free, constantly updated tables for mortgages, annuities, bank deposit accounts, RRIFs, GICs
- http://www.ifid.ca/ the Individual Finance and Decisions Center supports research into quantitative wealth and risk management for individuals, especially retirement topics, annuities and the like; much of the material is technical/mathematical but it has reprints from general press articles based on the research; one paper titled Can Buckets Bail-Out a Poor Sequence of Investment Returns? under the Personal Finance Articles compares the results for a retiree whose portfolio is invested in a balanced fund vs another who holds a combination of cash and equities, but they use different withdrawal strategies.
- http://www.soa.org/ the Society of Actuaries website has a free downloadable software package at http://www.soa.org/ccm/content/areas-of-practice/retirement-pension/research/retirement-probability-analyzer-software/

that allows you to estimate whether you will run out money in retirement using various assumptions about age of death, interest rates, investment in annuities vs stocks, bonds

Book Review: KPMG's Tax Planning for You and Your Family

This book has been a repeat purchase for me for a number of years and I note that the publisher Thomson Carswell has the 2007 available for ordering on its website. The topic coverage extends to pretty well all the common individual/family taxpayer situations, as can be seen on the above website, which displays the whole table of contents. The book can serve as both a reference manual to be used when a specific topic needs to be explored and a more general guide to be read for discovering new ideas that could be beneficial. In its 370-odd pages, the book covers a wide range of tax and financial topics and has been extremely useful to this do-it-yourself financial manager over the years. I would characterize it as addressing the intermediate to advanced level DIY person, though any intelligent beginner who is willing to read carefully could benefit. As much as the topic coverage, its usefulness stems from the presentation. The text is rife with appropriate references to other sections of the book where exceptions, special conditions and corollary information can influence what one should do. Each chapter has a list of pertinent CRA forms, bulletins and other documents that can save a lot of time poking around CRA's website. The Index is lengthy enough at about 18 pages to be a prime search tool. Since even DIY has its limits, the book inserts warnings when some action is so tricky or involved (usually it relates to legal matters and setting something up properly so one doesn't get caught out later) that expert professional advice is advisable, though I would say the book errs a little on the cautious side with such warnings. The writing style is direct, grammatical, logical and precise - just what is required to understand and take action. There are realistic mini scenarios with numbers to illustrate trickier points. All through the text there are suggestions for what a taxpayer can do to minimize taxes.

In summary, short of becoming a tax lawyer or an accountant, this is the most comprehensive, detailed and understandable book I've found for a serious DIY financial person.

RESP vs RRSP - The Best Approach is Clear

Update 2008...
Last year I compared a choice that parents often face - whether to contribute to an RESP for a child's education or to an RRSP - and concluded that the RESP was the better option. The maximum CESG (Canada Education Savings Grant) has gone up from $400 to $500 per year. That means the RESP contribution required to obtain the maximum amount of grant money from the federal government goes up to $2500, since the CESG is calculated as 20% of the contribution up to the maximum grant. The good news for 2007 and beyond is that last year's conclusion is the same - that the RESP is better. If you can contribute to both your RRSP and an RESP then by all means do so but if you have limited funds the RESP is the way to go.

Here is how and why that is so. Unlike this analysis by Jamie Golombek in the Financial Post that concludes "All things considered, perhaps the best plan is both plans.", and this Financial Post report of February 4, 2008, my own analysis shows that up to $2500 the RESP is a better choice.

First, I assume that a parent does not care whether he/she benefits or the child does and that the maximization of family wealth down the road after taxes is what counts. I have used similar assumptions about rates of return as Mr. Golombek just for convenience but my analysis is different to simplify and to clarify i.e. to compare only apples with oranges and not throw in lemons as well. Referring to the spreadsheet table ...in contributing $2500 to an RRSP, a taxpayer will receive a tax refund, which I assume to be calculated at the next to top Ontario marginal tax rate of 43.41%. That refund is assumed to be added back into the RRSP and the tax refund on the tax refund is also assumed to be reinvested. I've extended that chain of reinvesting the refunds for five years, until the amount gets very small (under $17 by year 5). Unlike Mr. Golombek I don't assume that the RRSP tax refund will be reinvested outside the RRSP in a some stock that produces capital gains. That element is the lemons I mentioned above. The reinvestment assumption enhances the RRSP option since the compounding occurs tax-exempt. The higher marginal tax rate also enhances the RRSP option since that will produce a bigger refund to invest at the beginning and a lower tax imposed upon withdrawal. For the RESP contributor, there is no tax refund to reinvest, only the $500 CESG grant to add to the initial investment amount.

I assume that the investments both earn 6% compounded for 18 years, which is the length of time Mr. Golombek sensibly uses since that is a normal maximum duration of contributions before a child enters post-secondary education. How long the compounding period lasts doesn't matter at all to the conclusion however, it just increases or decreases the advantage of the better choice. The 6% return is used for inside both the RESP and the RRSP, a cautious low number, indicating some sort of fixed income plus conservative equity investment. That rate doesn't matter either if it is the same for both.

Another thing (perhaps?) neglected by Mr. Golombek is that only the income from the RESP is taxable; contributions can be withdrawn tax free by the parent, the CRA logic being that the parent had already paid tax on them way back at the beginning. My last assumption (also not discussed by Mr. Golombek) is that the parent's tax rate is less when the RRSP money is withdrawn after 18 years since by then they will hopefully be retired. Whether or not the money would actually be withdrawn, the fact that there is a tax liability for funds within an RRSP needs to be taken into account. The lower withdrawal tax rate favours the RRSP option as well but alas, it is not enough! The only combination that makes the RRSP better than the RESP is when the parent's tax rate at time of contribution is very high and the rate at time of withdrawal is very low, e.g. the highest marginal rate of 46.41% (taxable income over $123,000) with the rate five brackets lower of 31.15% (taxable income of $37,885 to $63,428). How likely is that to happen?

Of course, if the primary objective is to save for a child's education then the RESP is the vehicle of choice. Using an RRSP to save, for 18 years in my example, would probably mean a much lower net return since the advantage of a lower tax rate at time of withdrawal, one of the essential benefits of RRSP investing, would be lost if the parent was in the peak of earning years and not retired. It might even be that the tax rate would be higher at withdrawal if the parent advanced to better pay in is/her career.

With both RESPs and RRSPs benefiting from tax-free compounding while a plan is in existence, the combined effect of income splitting with the child, who is highly likely to have little or no income tax to pay while in higher education, along with the CESG, make the RESP a better option by $55. BUT, the RESP advantage disappears for contributions over $2500. I haven't shown that table but remove the $500 CESG and redo the arithmetic to see it. Change the withdrawal tax rate up one bracket to 32.98% and the RESP is now ahead by $281. The RESP advantage also disappears when the student earns a lot and has to pay taxes, as in scenario 2, where the RRSP option is $1221 ahead after 18 years.

The example given in the Feb.4th FP article of putting $5000 into the RRSP and then putting the tax refund into the RESP produces less total wealth (RESP+RRSP value) after 18 years, considering the tax liability of the RRSP, than putting the first $2500 into the RESP and the remaining amount of $2500 into the RRSP - by $394.47 using the above base assumptions. In addition, whereas the RESP-first option produces an almost equal amount in each of the RESP and the RRSP, the FP way results in almost $3,000 less in the RESP. The differentiator is that the FP does not take advantage of the maximum CESG contribution.

Of course, there is a risk that children may not eventually attend high education. The rules do allow up to $50,000 to be transferred into the parent's RRSP in that case, providing there is contribution room. The CESG would be reclaimed by the government so that would be lost. The RESP would be less attractive in that case. The higher the level of education of the parents, the higher the chances of the children attending post-secondary education according to this Federal Government study. The same study says that in 2003, only 18% of families with children under 18 had an RESP. That's a shame since the higher education participation rate is higher than 18% so the CESG/RESP combination is thus much under-utilized.

In summary, to maximize family wealth, put the first $2500 into the RESP. After that, it goes into the RRSP.

Oh, and make sure the financial institution administering the RESP actually submits the form to the government to collect the all-important CESG; it happened more than once that my financial institution forgot to do so and I had to remind them.

RRSP Contributions in Kind - Beware of the Quirks

In case this helps anyone, here is a quirk of the way the CRA treats contributions in kind to an RRSP that almost caught me unawares a few years ago. It is possible to contribute shares or other eligible investments, for example from a non-registered account, to an RRSP and count the market value as a contribution. This avoids needing to make a cash outlay to contribute.

However, one needs to be aware of two things. First, there is a deemed disposition of the shares according to CRA rules, triggering capital gains and potential tax to pay on that gain. Second, and this is what almost caught me, there is not a corresponding deemed capital loss! One must actually sell the shares and realize the loss. One can transfer the cash and repurchase the exact same shares within the RRSP, after the 30-day waiting rule.

I am so glad to have bought the KPMG Tax Planning For You and Your Family book available from the publisher Carswell, which explains this subtlety. It avoided me missing out on those juicy capital losses on Nortel stock (no, I did not repurchase the Nortel in my RRSP).

Making Money or Giving It Away - Challenges are the Same!

One of the pleasures of making money is being in a position to give some of it away to charity. After all, as they say here is Scotland, shrouds don't have pockets. And I'd rather give it away myself than have the government do it for me. Once a DIY, always a DIY. However, given the effort and difficulties required to make the money in the first place, one doesn't want to simply squander it on bad or ineffective charities, of which I would guess there is the same range of fraudulent/incompetent to outstanding as there is in the investment industry.

It turns out that giving money away to good purpose is as difficult as, and requires many of the same competencies as, doing investment evaluation. Indeed, those who are good at making money seem to be pretty competent at giving it away when they are so inclined (Bill Gates of Microsoft comes to mind). In Canada in 2004, the Canada Revenue Agency is said to have estimated that there were more than 82,000 charities! One can even donate online - in Canada there is CanadaHelps.org. Assessment is a chore. For instance, the principle that overhead expenses should be minimized so that the maximum amount goes to the actual charity work is not so cut and dried as this article discusses. There is both over and under-investment in administration. Ideal ratios vary by type of charity work. There are performance metrics to compile and examine. And some charities pretend that their fundraising activities are separate from their program activities so that they can look good and state that all of the public's donations go to program work - sounds parallel to corporate tricks like off-balance sheet debt, n'est-ce pas? Not surprisingly, there are even advisor type charity ratings services like this, and this.

So, what's a person to do? What I've come to is what could be termed a following an informal mixture of Warren Buffett and Peter Lynch, i.e. select those charities one knows well, ignore diversification and choose a limited number.

One charity that passes muster for me is Child Haven International run by a couple who lived the talk of their work and adopted 21 children as this account details. I had occasion to attend a fund-raising dinner of Child Haven a few years ago and was highly amused by the difference in the way they came across when they spoke and the way the Ottawa TV station CJOH reported the event. The TV report was all about Fred and Bonnie Cappuccino as such wonderful people, which they truly are, but their modest and self-effacing remarks were all about the children and the work. They showed lots and lots of photos of smiling children, visible results of the work. Their solicitation materials are done very inexpensively, unlike the slick stuff produced by big-time marketers (a sign to me that a charity is spending too much on that administration/ overhead line item). It's a pleasure to give Child Haven money.

Duplication of Stock Holdings in Canadian iShares ETFs

It has been noted often in the past that actively managed Canadian equity mutual funds suffer a great deal from portfolio overlap due to the small number of companies on the TSX. It is hardly useful to buy several different mutual funds since they end holding more or less the same stocks. That has led me to wonder to what degree the same problem confronts the iShares Exchange Traded Funds. The various funds bear names that suggest different specializations and thus different holdings.

The image shows the summary of the spreadsheet analysis I compiled from the fund holdings on the iShares website as of February 20th. My conclusions are graphically summarized as red = bad, green = good and yellow = mediocre choices of fund combinations. Another way of saying this is that when the overlap of the fund holdings is too great (the red combos), it isn't worth holding both funds since one ends up with more or less the same holdings.

Based on that principle, XIU (iShares TSX 60 Large Cap) and XMD (Mid-Cap) have zero overlap (green cells) and make sense as a combination). So too are XIU and XRE (Real Estate Trusts). On the other hand, XIU with XEG (Energy stocks), XFN (Financial companies) or XDV (Dividend stocks) have too much overlap and do not make sense. XDV and XFN are more or less the same thing, being dominated by the banks. One might even wonder if the XFN and XMD are worth the 0.55% and 0.5% MERs respectively, instead of simply buying the stocks directly. Several funds are so concentrated on a few holdings that they are virtually a play on a couple of stocks. XIT (Information Technology) has only nine holdings and Nortel, RIM and Cognos make up 67% of its total value. ... highly risky if the past is any guide. XMD is a good Canadian compromise - it is middle of the road and has a bit of everything. The last combination that are more less the same thing is XGD (Gold) and XMA (Materials). XMA is more diversified with 61 holdings vs only 30 in XGD.

The number of holdings across all these nine specialty funds is still less than the TSX as a whole, with only 241 separate equities, against 273 in XIC, which is iShares' TSX market fund.

Now that I know, guess I'll have to simplify my portfolio some to eliminate the useless duplications.