Saturday, May 30, 2009

CPP Proposed Changes

Many people are hurting financially in this recession, and the government has decided to help out with changes to the Canada Pension Plan (CPP). This is the same kind of help you might get from a stranger who sees you need money badly and offers you ten bucks for your iPod.

For anyone planning to retire and draw from the Canada Pension Plan over the next 5-10 years, this will affect you and may ultimately make you decide to either retire early or later. There are several proposals on board but there are three that can/will dramatically affect your pension benefits.

Retirement pensions are paid monthly to all Canadians who have contributed to the Plan. The normal age of CPP take up is 65, but reduced pensions are available starting at age 60. For those who delay take up beyond age 65, pensions are increased up to the age of 70. In 2009, the maximum monthly pension amount payable at age 65 is $908.75.

Change #1

Currently, if you were to retire early, CPP reduces your monthly benefit by .5% per month for every month you retire before age 65. If you retire at age 60, you lose 30% of your benefit. If you wait until after 65, they add .5% for each year (up to 70). The plan now is the change the early "penalty" to .6% per month. If you take your CPP early, the reduction in pension amount is permanent. The pension will not go back up to the “normal” level at age 65. So, the extra .6% reduction will apply for the rest of your life.

Say someone is eligible for a CPP benefit of $900 per month. They are age 60 and want to retire now. With the current rules, they would receive monthly income of $630 per month. ($900 - 30% or $270). Under the proposed changes, that income would be reduced to $576 per month. This would mean a loss of $54 per month. For a person living to age 85, they lose $16,200 and that doesn't take into account inflation related increases. That moves the figure closer to $25,000.

On the other hand, with the proposed changes, if you wait to collect after age 65, you will receive a bonus of .7% per month. The same person retiring at age 70 would see their benefits increase to $1215 per month. The trade off is that they would only receive benefits until they die. If they were to live to age 85 (as above and ignoring inflation related pay increases), the 60 year old receives $172,800 and the 70 year old receives $218,700. If you were to factor in inflation of 3%, the numbers change. The 60 year old gets roughly $250,000 and the 70 year old gets roughly $271,000.

The combination of allowing people still working to draw early CPP along with being in a recession may cause many people to make the short-term decision to draw CPP early. The government is right there to help them out with a low ball offer of 36% reduced CPP payments. From an actuarial point of view, this increased early penalty makes little sense because people are living longer. The longer you live, the less enticing a reduced early pension becomes. From the point of view of taxpayers, this is a good move by the government. CPP payouts will increase somewhat in the short term, but over the long run, the total benefits paid out will be lower.

Change #2

The CPP retirement pension amount is based on the number of years a person has worked and contributed to the Plan, as well as the salary or wages he or she earned. Specifically, it is calculated as 25 percent of an individual’s “average career earnings”, starting at age 18 and ending at the age of CPP take-up. If, for example, an individual takes the CPP at age 65, the span of the career is considered to be 47 years. If, for example, the CPP is taken at age 60, the span of the career is 42 years.

The average of earnings over the span of the career is calculated allowing for 15 percent of the years where earnings are low or nil for whatever reason (e.g., full-time post-secondary education attendance or spells of unemployment) to be dropped. This provision is called the “general low earnings drop-out”. The 15 percent gives individuals who take their CPP at age 65 almost 7 years of low or zero earnings years that can be dropped from the calculation of their average career earnings. In addition, there are drop-out provisions specifically for child rearing and periods spent receiving a CPP disability benefit.

These drop-out provisions are intended to ensure that an individual’s average career earnings are not affected by a certain number of years of unusually low earnings that occur in most people’s career for various reasons. Virtually everyone benefits from the CPP’s drop-out provisions. Without these provisions, virtually everyone’s “basic” pension amounts – that is, the pension amount if the CPP is taken-up at age 65 without any adjustments for early or late take-up – would be lower.

Under the proposed changes, the 15 percent figure would increase to 16% then to 17%. This change would benefit virtually all CPP contributors and improve their basic retirement pensions. It would also increase the average CPP disability and survivor pensions, as the calculation of these benefits is based on the retirement benefit calculation. While the change would increase the average retirement benefit of virtually all contributors, it would be particularly helpful to those whose careers suffer more work interruptions for a variety of reasons. For instance, those who pursue post-secondary studies or other educational opportunities, those who reduce their participation in the labour force to provide care to a family member, or those who immigrate to Canada as adults are all more likely to find this measure especially helpful.

Change #3

You will be able to draw CPP at age 60 while still working without taking two months off. This is welcome news for older workers who have been laid off and are having a hard time getting by on half as much pay at a new job. In other words, you don't have to "retire" and then go back to work later. This may be an attractive thing to someone forced out of an old job, who resumes one at a lower income.

Jonathan Chevreau of the Financial Post had 3 actuaries discuss the situation in greater detail. Don’t blame people who choose to take early CPP despite the extra reduction. It’s possible that a person’s unique circumstances make this a wise choice. For years I have been telling single people that they should almost always take it as early as possible. Unlike someone with a spouse, if they die, their estate receives a cheque for $2500 AND THAT IS IT. At least with a couple, their is a monthly benefit paid to a surviving spouse. Unfortunately, people will often make choices based on their immediate needs. The one good thing about these proposals is that the changes will allow the government to maintain current funding levels. At least this means you don't need to pay more to get less.

It’s good to know that when people are hurting, the government is right there to say “I’ll give you a hundred bucks for your car.”

Stay Well and Pay It Forward.

Wednesday, May 20, 2009

Mortgage Planning Going Forward

So you currently have a mortgage and you're wondering what direction to go. When does it renew? Is it a variable or fixed rate mortgage? When will rates increase?

These questions are becoming very important in the eyes of homeowners in Canada. The following will attempt to explain the types of mortgages and provide some guidance on what to do over the coming months and years. The following summary of current market conditions was "borrowed" from a blog on mortgages. Here are the basics in the various types of mortgages.

Popular Fixed Term

1-year fixed: With rates under 3%, they’re a good alternative to 5-year variables—which should hopefully be at prime by the time these puppies mature next May.

2-year fixed: If convertible (mortgages with a convertible rate feature allow borrowers to move into a fixed rate at any time with no penalty - you generally need to choose a fixed rate term that is at least as long as the term you have remaining), then they’re another decent alternative to 5-year variables. You get an extra year of rate security for 0.20% more than the best one years.

3-year fixed: A nice combination of risk and reward. Versus a 5-year, you’ll save significant interest the first three years. The trade off is more risk in years 4 and 5.

4-year fixed: The ugly baby that no one wants. There’s no value here. Go 3 or 5 instead, unless you plan to break in four years and want to avoid a penalty.

5-year fixed: Canadians love their 5-year terms. Now may be the time for the risk averse to grab one, with rates expected to jump later this year or next.

Longer Fixed Term

7-year fixed: A rate near 5% is not as exciting as 3.79% for a 5-year, so 7-years don’t sell very well. If you’re that concerned about risk take a 10-year for the same price.

10-year fixed: The decade mortgage is available under 5% for the first time in modern history. Nonetheless, you may pay thousands more in interest versus a 5-year.

Variable Term
5-year closed variable: They say prime is not going any lower. So why gamble with prime+ variables? Get a convertible 1 or 2-year and wait for prime- to return.

5-year capped variable: You’ll get 3.25% today and never pay over 5.25%. Sounds good, but if you’re that worried, why not pay a little more for a fixed now?

5-year open variable: Closed variables are portable and have just 3-month interest penalties. So, unless you’re going to terminate early, save 0.30% and go closed.

Several people have asked me over the past few weeks "what should we do"? Here is a simple answer. Look at your current mortgage.

For old style "variable" rate mortgages, you are likely paying prime minus .4-.8 percent. Stay there for the time being. If you are concerned about long term rates, lock in once the five year rate starts to climb. For people in existing five year terms with 2-4 years left, the fee to get out of the mortgage is too high to make it worthwhile. Consider the idea of doing a blend and extend (for 5 years from now). It will reduce your rate BUT WAIT FOR A WHILE TO DO THIS. Rates are expected to remain relatively low for the next 2-4 months and the prime rate is not expected to change for 6-12 months. The shorter time let in your 5 year term, the better. When your lender does the blend and extend, it will mean a slightly lower rate.

Find a mortgage broker. They earn their incomes by placing mortgages with various lenders. If you were to go shopping around to various lenders, it will actually hurt you as it reduces your "beacon score" which is what creditors look at to consider your credit worthiness. Mortgage brokers apply once on your behalf to 20-30 different institutions. They do all of the work.

Lastly - we never can tell where mortgage rates will go. Current rates are at the lowest levels ever. Governments are flooding markets with cash. For anyone under 35, ask someone what it was like to pay 10-18% for a mortgage. Think it won't happen again? Unlikely, but let me ask this one simple question.
If rates were to go to 8%, could you afford your current mortgage?
Stay Well and Pay It Forward.

Thursday, May 14, 2009

Market Fluctuations - What Should I Do?

A few days ago, a person asked me to review their investment portfolio. They explained that they were fairly conservative, and wanted a "second opinion" of their investments. They had all of their money at a "bank" and were not happy that the person advising them had told them to to stay the course, while they were freaking out about the market dropping like a stone last fall. Neither had a pension plan at work, and this money was their entire retirement plan. They wondered what they should do.

Any decision made while freaking out is rarely the right one. Let's start with some data. When it comes to investing, human nature is not our friend, and will consistently lead us to do the wrong thing at the wrong time. In fact, one of my own investing mantras is "whatever you think you should do, then do the opposite".

History has shown us that we pour money into the stock market after the great years and panicked and sold during and after declines. This creates a clear pattern of buying high and selling low, something I'm pretty sure investors didn't consciously set out to do. Buying something on sale is the first thing we'd do if we were shopping for almost anything else, from electronics to a house. That logic is conspicuously absent when it comes to the stock market. For whatever reason, we'd rather return them at a lower price than we bought them for.

Past studies have consistently shown that our ability to consistently time the market poorly costs us roughly 1.5% annually in returns. Investors in both actively managed funds and index funds exhibit poor investment timing. If only retailers had it so good.

Think of your favorite retail store. Whether you favour a small boutique, a local shop, or one of the big box stores, we are usually more inclined to buy something we want when the retailer has a sale. Imagine that one day your favorite store had a "we've doubled our price sale," followed by a "50% off sale." We'd all shake our heads at the absurdity of getting in line to buy at the first sale, only to then rush back and return the items at 50% of our original price. It sounds silly, yet that's exactly what most of us do in our investing. And we do it with a lot more money than what we would spend at any store.

One of the most important roles of a good adviser is to provide some focus and discipline in your investing. I have often likened the role of an advisor to being a pilot. If you are flying from Toronto to Hawaii and the pilot is off by one degree, you end up missing Hawaii by hundreds of miles. The best advisor is consistently and constantly reminding you of your goals and objectives. When you begin to get off track, it's his/her role to get you back on track. In doing so, he/she is trying to protect you from your own human instincts, which will almost certainly fail you. My advice: While I know that I don't know what the market will do over the next six months, there are some things I do know.

  • I know that we will consistently buy high and sell low if we react to our emotions.
  • I know that money coming out of stock mutual funds is often a sign that the market will turn around.
  • I know that the market has rarely lost money over periods of ten years or longer.
  • I know that these are the times that try investors' souls and separate the speculators from the investors.

  • My advice to the person was to stay the course. It turns out their concerns over the "bank" was a lack of communication. We solved that problem. Find out what type of investments are right for you. Figure out how much of your money to put in each type of plan. Then stick to the plan like glue.

    Stay Well and Pay It Forward.

    Tuesday, May 12, 2009

    So You Got A Refund...

    So you filed your income tax return and you are getting a big "refund". Images of what to do with that money begin to form in your head. A new flat screen? A trip? Just what to do with the money?

    It never ceases to amaze me how often people are fooled into believing they got a refund. It was not a refund. YOU OVERPAID TAXES DURING THE YEAR GIVING THE GOVERNMENT AN INTEREST FREE LOAN.

    One person was excited to see they were getting a $4800 refund. I then explained, they could have had an extra $400 per month to live on for the past year.

    Is there a perfect amount of money to owe/get back? Sure there is. If you look closely, the CRA (Canada Revenue Agency) states that amounts of under $5 plus or minus are waived. The perfect refund is actually having to pay them $4.99 which gets waived. So what can you do about your own situation?

    If you consistently owe money to the government, either you are not paying enough taxes during the year, or you are not taking advantage of all of the deductions available to you. There are actually several measures the CRA allows for average "working" Canadian citizens to take advantage of.

    1) Deductions for children - aside from the basic dependent deduction of $2000 per child up to age 16, there are the fitness (up to $500 per child) and child care deductions. It amazes me to find out people don't know they can claim a "child care" deduction for a week of summer camp IF the reason is for child care.
    2) Public transit - save your receipts and deduct costs for all forms of public transit.
    3) Medical expense tax credit - if you have high medical expenses (and the CRA is very generous as to what qualifies) then make sure you claim for this tax credit.
    4) Travel allowance - if you need to travel some distance for regular medical treatment, you may be able to claim the mileage driven.
    5) Maximize RRSP's during the year - did you know that if you make monthly contributions to RRSP's, you can file the appropriate tax forms with the government and your income taxes deducted will be reduced.
    6) Charitable donations - do not really make an impact unless you make significant donations - have the higher income earner claim them and perhaps accumulate them over time then deduct them.
    7) Disability benefits - one of the most significant areas for deductions deals with disabilities. A few years ago, I explained to a relative that his hearing loss may qualify as a "disability". He had never claimed it - now he gets to claim it and his spouse gets to claim the "caring for a related disabled person" benefit.

    There are other ways to save money as well - these are just some basic ones - remember to forward a copy of your notice of assessment and T1 General to your advisor - they can often spot an overlooked "deduction". A simple letter after the fact can often put some money in your pocket.

    As always, Stay Well and Pay It Forward

    Friday, May 8, 2009

    Pension Plans - What Are The Differences?

    With retirement being a hot topic in personal finance, one common question I get on pensions is what are the differences between a defined benefit pension plan and a defined contribution pension plan. Even though they have similar names, they have vast differences as to what it means for the retiree. They work differently and the resulting differences can be enormous.

    Defined Benefit Pension (DBP)
    A defined benefit pension (gold-plated) is just as it sounds. The payout, when it comes time to collect, is fixed to a certain formula. The formula is typically a combination of years of service multiplied by a percentage of your average salary over the last several years of service.
    A typical government defined benefit plan will offer 60%-70% of the employees average salary over the last several years of service once they reach the 30 to 35 years of service mark. So for example, my wife is on a defined benefit plan with the government. When she is in her early-mid 50’s, she will have accumulated over 30 years of service at which point she’ll be entitled to around a pension of around 66% of her working pay. If she reaches the 35 years of service milestone, she will receive around 70% of her working pay during retirement.

    Defined Benefit Plan Advantages

    Retirement income is independent of market performance and usually adjusted for inflation. In addition, retirement income is relatively high (up to 70%) for the amount of contribution the employee makes. The higher income years prior to retirement really works to the employees advantage.

    Downside of Defined Benefit Plans

    Defined benefit pensions are extremely expensive on the employer which is why most companies are, or have switched, to a defined contribution plan instead. The biggest risk with having a non-government defined benefit plan is that there’s the possibility of the pension not being funded properly. Another disadvantage is that some DBP’s only allow a portion of the pension to be transferred to a spouse if the beneficiary passes away. Whereas an RRSP is more flexible where all assets can be transferred. They also limit contribution room for RRSP's.

    Defined Contribution Pension (DCP)

    Instead of the benefit being fixed, a defined contribution pension plan has a fixed contribution usually based as a percentage of the employees salary (usually employer matched). The benefit is dependent on how the portfolio performs with no guarantees as to how much income you’ll receive during retirement. For the astute investor, a defined contribution plan has the benefit of total control over the money/portfolio. The investor can choose various funds and asset allocation within the plan.

    Defined Contribution Plan Advantages

    You get to watch your money/portfolio grow; what you see is what you get. In addition, you maintain control over your money and investments within the plan.

    Downside of Defined Contribution Plans

    Within a DC plan, your retirement income is entirely dependent on how the portfolio/market performs over the vested period. Even an employee who has no interest in finances needs to be involved with the portfolio. As well, employees need to take advantage of the plan by maximizing contributions.

    Final Thoughts

    Typically speaking, an employee does not have a choice as to whether to to enroll in a defined benefit plan or a defined contribution plan. It’s usually one or the other depending on the company. Defined contribution plans are becoming more popular as they are much less risk to the company and arguably the employee as well.

    Stay Well and Pay It Forward.

    Wednesday, May 6, 2009

    Beginning of the End ?

    When I originally started blogging last fall, it was to present people with the "entire story" as opposed to the portions that mainstream media love to tell you. Words like crisis, disaster, depression and doomed seemed to make it into the vernacular of average Canadians. One of the benefits of the economic downturn we experienced in 2008 was the fact that John Q Public began paying more attention to their investments. However, the recent run up in global stock markets has not received the same media attention. Shockingly, many people are unaware that their investments have increased at all. Here's hoping that the message gets through and that people will feel more comfortable saving for their future and less prone to "panicking".

    Back in March, Ben Bernanke pronounced the end of the recession was coming by the end of this year with the recovery beginning next year. It was at this time that the theory of "green shoots" was advanced. These green shoots referred to small areas of the economy that were moving higher without regard to general market conditions. A good Canadian example is RIM (Research in Motion). They have been able to show significant growth and productivity regardless of market conditions. Hopefully this trend spreads to other areas of the market.

    So what are the actual numbers? Since March 8th, the TSX is up over 30% and is in fact up over 10% year to date. US markets have experienced similar growth. Does that mean the bad stuff is done with? Not likely, especially within certain sectors of the US economy. US regulators did "stress tests" on the 19 largest US banks and it was determined that four (Bank of America, Wells Fargo, Citigroup and GMAC) need another $60B to offset possible losses in the future.

    In April, there was a bear attack in Toronto. A what? Nouriel Roubin at left (Professor of Economics, New York University's Stern School of Business) and Eric Sprott, chairman and CEO, Sprott Asset Management are two well known believers that the markets are still in for trouble. In a interview in early April, they explained that Canada is in better shape financially than other economies (specifically the US), but the impact of the US economy affects all global economies. They feel that there are still problems, and that it may take until later in 2010 for the economies to recover. They believe the recent run up in the markets is a bear market rally. Whether that is true will only be known when we look backwards in 1-2 years. They also point out that the inability of global governments to raise tax levels will lead to other weaknesses in the economy.

    Last fall, I pronounced a bottom to the market in late November. Markets climbed for three months and then bottomed out in early March. Since then - ZOOM. Is this the beginning of the end of the declines or a bear market rally? The interesting thing will be watching the reaction of people to their semi-annual investment statements in early July.

    Stay Well and Pay It Forward.