Entries from November 2012 ↓

New rules

Eddy says if you need a root canal, “I’m your guy. I almost make it fun.”

As riotous as the procedure might be, the 52-year-old Markham dentist also tells me business sucks lately. Seems even in his affluent community in the northern reaches of the GTA, where houses routinely cost seven figures, families are eschewing major dental work since they don’t have the dough. If a tooth breaks, and it’s not covered by insurance, that sexy white cap can wait a while.

(As an aside, the auctioneers at Sotheby’s were shocked Tuesday night in Toronto when a slew of quality Canadian paintings went under the hammer. Works expected to fly out the door remained unsold. In fact, a third of the lots were still sitting there at the end of the night, with the event bringing in millions less than expected. As one life-long collector put it to me the next morning, “You just saw history. Even the rich are flipped-out about their mortgages.”)

Eddy’s wife works in the dental office. Together they bring home about $250,000, at least for now. Self-employed, no pensions. Their house is worth a million, with $180,000 left on the mortgage. Three kids, two of them expensive teenagers. Total liquid assets: $175,000 in mutual funds inside two RRSPs.

“Jen and I were discussing whether or not we need to change anything,” he says. “We talked about paying down our mortgage versus investing that money.  She is the math person in the family.  She can see investing the money instead of doubling up on the mortgage if the mortgage wasn’t so high or if the investment and the mortgage amounts were close to equal.  She prefers the old school thinking of paying down the mortgage first.  This is the way both of us were encouraged to do things and continue do so.

“I respect Jen for her caution.  But how do I make a case to convince a leery wife the old way our families always did it isn’t the right way?”

Well, after all the moaning on this blog yesterday from people who cannot find $5,000 in a year to put into their TFSA, Eddie and Jen may seem like royalty. But if it weren’t for the cash the dentistry thing has thrown off in the last seven years, these guys would be victims of their own family funk. As it is, they’re at more risk than they realize.

For starters, bringing a quarter million a year into the household and ending up with less than $200,000 in liquid, investible assets in your fifties is not cool. Obviously they’ve been spending excessively, plus channeling cash into one asset – the house. So the second problem is a lack of diversification. Here’s a net worth of almost a million bucks, with 80% of it in one thing. Worse, that thing is almost guaranteed to lose value over the next few years as 905-area real estate – especially at that price point in a glutted market – withers.

Third, no pensions. And yet they’re spending most of $250,000 in annual income. So even when the kids leave home they’ll feel impoverished if they take a 50% or 70% income hit once Eddy retires (and he already sold his stake in the practice). Obviously $175,000 in RRSPs won’t last more than a year or two. Then what? Try to unload the palace in a housing vortex?

Fourth, they have no non-registered investments, meaning every dollar being invested now becomes taxable in retirement. No TFSAs, either. And their retirement stash is stuffed in do-nothing bank mutual funds with management fees high enough to negate any growth.

In fact, the net return on the million dollars of net worth: zip. And Jen thinks the best course of action is to keep throwing money at a 2.8% mortgage, thereby increasing the real estate imbalance. Why? Because that’s the family groupthink, and it worked in the past.

But no more. In a quasi-deflationary world all the rules are changing. Real assets have a rocky future. Liquidity will rule. Financial markets will trump the housing market. Having the bulk of net worth in one property at one address, in the burbs no less, is asking for heartache. After pushing prices to heights of stupidity, debt’s now sucking the life blood – cash flow – from society. If it weren’t for cheap mortgages, real estate would collapse overnight. If not for credit cards and LOCs, Best Buy would empty. So when it comes to paying for stuff with real money – like a G7 painting or a fun tooth demolition – you can glimpse the future.

Eddy, you need to renovate your finances. Stop doubling up payments on a mortgage costing barely more than inflation, and shoveling more money into the same furnace. You’re far better off to put the next $50,000 into TFSAs, and fill them with equity, REIT and preferred ETFs. Then start building that joint non-registered account with a balanced and diversified portfolio heavy on dividend income. Income split with Jen. Incorporate and take remuneration through company dividend payments so you collect the tax credit.

Tap into some of the $800,000 in dead equity inside the McMansion. For example, borrow money against it at prime (3%) and invest it in bank preferred shares (5%). The interest on the loan is deductible, which means it effectively drops to 1.5%, at your income. Meanwhile the dividend tax credit means the equivalent yield on the preferreds is greased closer to 6%, while they remain stable, liquid, dependable, high-quality assets that will certainly outperform your house. Why would you throw money into real estate paying you nothing, with the capital at risk, instead of profiting from a spread of four points on borrowed money?

In fact, sell the sucker. Take your million, get it managed properly, and spin off enough income to rent a better suburban palace for five grand a month – while retaining the principal for the years ahead when you’ll sorely need it.

The worst strategy? The one you’re following.

Jen’s caution is worst than a root canal. No offense.

The doomed

Lost in the swirl of events this week – Sir Carney, America’s housing renaissance (hey, Phoenix prices are up 20.4%) and the on-again fiscal cliff theatre – was Monday’s jacking of a tax shelter Canadians love to abuse. This deserves a few words, especially since the increase in TFSA contributions was dissed by a bunch of financial advisors who couldn’t manage a sock drawer.

The change was simple – you can put in 10% more next year. That means a husband and wife’s combined annual limit is $11,000 in 2013, and the total of contributions to date, since the TFSA was invented by a pathetic failed politician, is $51,000. If you can, you should do this. There are many reasons why the tax-free savings account (despite its name) is rapidly becoming the main vehicle for financing the future.

Yes, I know you get a tax deduction for sticking money into an RRSP, and you don’t with a TFSA. But seriously, this is like sex. Without that instant gratification, who would go through with long-term stuff like kids or retirement planning?

After all, by putting money into an RRSP you’re making it taxable again. This doesn’t ‘save’ anything that you’d otherwise have to pay to the government. It merely delays it until a future date when paying will hurt as much. Maybe more. Given the fact our national debt just hit a new record, do you seriously think personal tax rates won’t be swollen in two decades? Are you willing to risk it?

Remember that all withdrawals from an RRSP down the road are taxed as income, at your marginal rate. Not so with TFSAs, which can be looted without any tax consequences. Besides, you can have a fortune tucked inside a TFSA thirty years from now paying you big bucks, and it won’t even be counted as income or cause a claw-back in any of your geezer benefits. Meanwhile investments inside a TFSA grow just as quickly as in an RRSP, and you can stuff them both with the same cool stuff. Never forget, too, that you can contribute to tax-free accounts in your name, that of your spouse and your 18-year-old kids and later force them to give it all back to you, plus the non-taxable gains. This is called ‘income-splitting’. And ‘divorce without custody’.

But there are two problems.

First, shockingly few people get it. There are 8.2 million Canadians who have opened tax-free accounts over the past four years. But almost six million of them couldn’t scrape together $5,000 last year to max out. Worse, eight in ten actually put savings in their tax-free savings accounts. They believed TNL@TB and stuck their money into high-yield (LOL) deposits or those hideous GICs. Squandered. Totally.

Just another six million bricks in that giant retirement crisis wall so many people are headed for. Millions of us have yet to learn the basic lesson of modern finance: you’re way more likely to run out of money than you are to lose it. The biggest risk lies in desperately trying to avoid risk.

The second problem, tons of folks reading my comments will think I’m being elitist. They might believe the financial advisors quoted in media articles this week pooh-poohing F’s TFSA sweetener who said this is little more than a suck-up to the 1% among us. “This is Mitt Romney-eque in its public policy implications in that while you could argue that it is good public policy in principle, in practise most people will say this is neither here nor there because they can’t afford it,” said advisor John DeGoey, who is normally a smart guy. Another, Kurt Rosentreter, said his clients under 45 are too busy diddling with their mortgages to save anything.

Comments like this should scare you. A generation ago people aged 45 were saving 12% of their incomes and building liquid assets, helped along by fat interest rates. Today, middle-aged adults are often still dragging around student debt and have bought absurdly-priced houses with the lowest down payments in history. No wonder most are screwed; that only a quarter of people can find five grand a year to invest; or that a houseageddon awaits when mortgage rates normalize. As for financial literacy, forget it. When known advisors pee all over a tax shelter enhancement, it’s done. We’re doomed. Save yourself.

In a society where 70% of people are homeowners, only 40% of Boomers have saved a hundred thousand and almost eight in ten have no pension, you can see where this is headed.

If you’re a middle-aged, middle-class, employed person who can’t find $5,500 next year to invest, ask yourself why. I already know.