The price of security

Behind many savings plans lurk steep costs. Who can you trust?

Michael Popovich, a dentist, suffered a massive heart attack at age 52. His doctor, not surprisingly, told him that going back to work was a bad idea. Faced with the sudden prospect of losing several of his prime income-earning years, Popovich sold his dental practice in Thamesville, Ont., and began searching for a way to fund his unexpectedly long retirement.

Like many Canadians, he was attracted to the reliable monthly income stream that came with investing in income trusts (unlike corporations, trusts pay out most of their profits to investors). But he was forced to rethink his investing strategy after Ottawa said in 2006 that it would begin taxing the popular investment vehicles in four years, citing concerns about a loss of tax revenue. The value of Popovich’s holdings plummeted overnight.

Now, three years and one market crash later, he is one of millions of Canadians trying to retool their retirement portfolios. While some financial advisers are no doubt telling clients it’s a good time to get back into the stock market, you can’t blame people for being a little gun-shy. But playing it safe in an era of historically low interest rates isn’t a magic bullet either. “There are very few good options out there,” Popovich says. “Interest rates aren’t going to come back for a long time so you can’t count on that. Corporate investments are iffy because you don’t know where you’re going to go with those things.”

Financial institutions have taken notice of the dilemma and have rushed to devise a host of so-called “safe” investment products peppered with buzzwords like “protection,” “guaranteed” and “security,” but that still promise equity-like returns. Not surprisingly, though, the risk reduction comes at a price—often a steep one.

It’s a confusing landscape littered with hidden fees and potential ticking time bombs—all at a time when a do-it-yourself investing strategy is becoming more important than ever. The days when Canadians could depend on a company pension for a comfortable retirement are rapidly slipping away. “The demographics of our country, in terms of our aging population, and the status of our pension plans means [Canadians] have to save and invest for themselves,” says Alexander Irwin, the director of the Canadian Retired & Income Investors’ Association. “But as many come to live on their savings, they will discover they don’t have enough to live on.”

That is, of course, unless they manage to invest wisely, something that these days is often easier said than done.

A recent industry poll suggests that nearly a third of Canadians planning for retirement are now investing more cautiously, up from just 20 per cent a year ago. The trend doesn’t surprise Tom Hamza, president of the Investor Education Fund, a non-profit group established nearly a decade ago by the Ontario Securities Commission. Hamza says there has been a noticeable increase in the number of people seeking information about guaranteed investment certificates, or GICs, on the group’s website.

With caution the new buzzword, financial institutions have stepped in with an increasingly wide array of products that promise investors exposure to market gains while guaranteeing they won’t lose their principal. The advertisements sound like the perfect blend of minimal risk and maximum return. But experts warn such products aren’t always what they are cracked up to be.

On the GIC front, the trend in recent years has been toward so-called market-linked GICs. CIBC’s Stock Market Advantage GIC is a typical example. For a minimum investment of $500, it offers the chance “to take advantage of the growth potential of investing in Canadian stock markets, but with full protection of your principal.” The trade-off is that investors aren’t exposed to the market’s full upside potential, but are instead offered a “participation rate” of 35 per cent for a three-year term. They only enjoy a portion of the market’s gains each year. That’s potentially better than a plain vanilla GIC if the markets do well, but if the markets stay flat or fall, as they did last year, investors risk earning no interest at all on their investments after parking their cash for 36 months. While some market-linked GICs do offer guaranteed minimum returns, the minimums are generally less than what a regular GIC would guarantee over the same period.

Other guaranteed products can be even more complicated. Take principal-protected notes for example. They promise investors the chance to participate in complex hedge-fund-like investing strategies while guaranteeing to return the initial investment after a certain period—typically 10 years. The drawbacks, in addition to a complicated structure that most investors will probably never hope to grasp, are penalties if you try to withdraw early and opaque management fees associated with the underlying investments that eat into potential returns. Similarly, segregated funds—mutual funds sold by life insurance companies that guarantee to return a portion of the principal after a certain period—can be costly for the same reasons. “There’s a feeling of safety that you pay for,” says Hamza. “And you pay for it in fees.”

Another increasingly popular investment category is the guaranteed minimum withdrawal benefit plans sold by Canadian life insurance companies. Manulife Financial was among the first out of the gate in Canada with its Income Plus product, which has accumulated some $10 billion in assets in three years. The plans, also known as variable annuities, target baby boomers close to retirement who are afraid they will outlive their savings. Investors essentially hand over their retirement savings in exchange for guaranteed minimum annual payouts, say five per cent, over a set period—usually 20 years—or for life after the investor hits age 65.

It also gives them the opportunity to increase the size of their monthly payouts by spreading their investments across a lineup of segregated funds run by third-party managers—providing, of course, that the underlying funds outperform pricey annual fees. If the markets do badly and the original investment is ravaged, the guaranteed minimum payout levels are maintained.

Greg Holohan, a financial adviser with ScotiaMcleod, says a key problem with any guaranteed product is not necessarily the cost, which may be justified depending on the value investors place on security. What concerns him is the overall complexity. “The fine print is absolutely huge,” he says. The reality, he says, is that many investors often have no idea what sorts of financial instruments they are actually purchasing, which can be a recipe for disaster down the road. He recommends that investors stick to what they understand, even if the potential benefits don’t seem as eye-popping. “People need to try and make it as simple as possible. At least that way the risks are identifiable.”

S tan Buell, president of Canada’s Small Investor Protection Association, says he will never forget the time he slipped into a chair near the back of a conference workshop on derivative-based investment products. For those who are unfamiliar with derivatives, which is likely most of the population, they are complicated financial instruments that allow traders to speculate on the movement in value of an underlying asset, as opposed to trading the asset itself. Oil futures are one relatively straightforward example. Credit default swaps, a type of derivative that threatened to exacerbate the U.S. mortgage-backed securities meltdown, are another. Credit derivatives were also fingered in the $32-billion implosion of Canada’s market for asset-backed commercial paper—a supposedly “safe” investment that stung everyone from small investors to major corporations.

“There were regulators and industry people there, but I had a blue suit on, so I looked just like everybody else,” says Buell. “I was amazed at some of the things that were being said in public. They were making gross amounts of money and even the people selling these products don’t understand them.”

It all raises the question of who investors are supposed to turn to when everyone is eager to get a hand in their pocket and the rules of the game can border on incomprehensible. The answer, according to Buell, is not always comforting. While most financial advisers are honest, hard-working people, Buell says that the system is stacked against the small investor since many advisers, although not all, are paid commissions based on the investments they sell. And while investors are ultimately responsible for their own decisions, Buell says they are effectively pitting themselves against the legions of high-priced financial professionals who have created the investment products in the first place. “There is such a proliferation of product, the average individual can’t evaluate it,” says Buell. “They don’t know what’s good and what’s bad.”

He recalls a story of one retiree who was encouraged by her adviser to invest in a leveraged mutual fund, a highly risky investment that promises to magnify investment returns by using borrowed money. Of course, the flip side of such as strategy is that potential losses are magnified as well. “People can lose their shirt.”

Even relatively straightforward investments such as mutual funds, held by nearly half of all Canadians, are riddled with fees and charges that can be easy to miss. Don Johnson is a retired journalist who lives in Victoria and is fed up with the fees associated with investing in funds. He has launched a letter-writing campaign to regulators and investing firms calling for greater clarity in how they disclose information to investors, taking particular umbrage with a unique Canadian creation called a “trailer fee.” Baked into the management expense ratios, or MERs, charged by mutual funds, trailer fees are meant to cover the ongoing expenses and commissions of professional financial advisers and effectively act as a sales commission. “I sometimes ask my friends, ‘Do you pay trailer fees?’ and they say, ‘I haven’t got an RV,’ ” Johnson says. “Most people don’t know anything about the fees they pay, and that’s by design.”

The question of mutual-fund fees has been a hot topic in recent years among Canadian investors. While there’s nothing inherently wrong with MERs—funds do have expenses after all, including management salaries, research, distribution and marketing—the professional services investors are paying for don’t always yield a market-beating performance. And the higher a fund’s fees, the better it needs to perform in order for investors to make money.

A report released earlier this year by Morningstar gave Canada a failing grade when it came to mutual-fund fees. “Canada has notoriously high management expense ratios,” the report said, adding that the typical investor in a Canadian equity fund pays an MER of between two and 2.5 per cent. “Canadian investors do not pay much attention to fees” and are comfortable with them “because they don’t know how low these fees should actually be.” The report claims that because Canadians tend to rely heavily on advisers to make investment decisions, their money tends to get directed into funds that pay better trailers and, hence, higher MERs.

High fees are partly responsible for the growing popularity of exchange traded funds in recent years. ETFs offer lower fees and function as a sort of cross between stocks—they are purchased from a broker and trade on major exchanges—and a mutual fund that allows investors to buy into a portfolio of investments.

While it might strike some as unseemly to sit down with a financial adviser and immediately inquire about how they get paid, Holohan says it’s critical for investors to be able to have upfront and frank discussions. He stresses that not all fees are bad ones and that there is a time and place for more complex investing strategies, depending on the individual circumstances.

In the end, though, it all comes down to being educated about your portfolio and realistic about its ability to deliver returns. “Don’t get cute,” says Holohan. “Don’t try to outsmart everyone and everything out there. And make sure the level of risk is appropriate.” Otherwise, your investments are likely to be making everybody a nice chunk of change—everybody, that is, but you.

The price of security

  1. This is why a supplementary pension plan, administered by the CPP/QPP or new public pensions, is a great idea. Most people are baffled by all the choices available and end up making disastrous investment decisions.

    • Our Manulife rep tried to convince us to get into the Income Plus program. We stopped investing with him several years ago as we saw our gains continually decreasing. He moved our investments into less risky ones with lower MER's but we still took a big hit last year but have recovered somewhat. Our rep knew we had more money to invest as we have no mortgage and absolutely no debt. I did some research on the Income Plus plan and sent him a few links, mainly forums and articles. Based on the research I said thanks but no thanks.

      I'm thinking we might buy some bank preferred shares as the banks seem to be the only ones making big bucks, thanks partly to we taxpayers now assuming all the risk (via CMHC) on those mortgage loans the banks so freely offerred to clients who are in over their head in debt.

      http://americacanada.blogspot.com/2009/07/cmhc-an

  2. I trust that everyone is aware that the Governor of the Bank of Canada is a former employee of Goldman Sachs. He was the one who insisted that Income Trusts have got to go. What is the connection between Goldman Sachs and Income Trusts. Do they feel that it is bad for business? The little guy is always the sucker!

  3. Income trusts were a way for people who owned shared to avoid double taxation, once at the corporate level, then again (less a dividend tax credit) at the personal level. The fact is corporate profits are taxed twice, and the government seems to think this is ok.

    • To a degree. They do avoid double taxation, but usually result in a single tax rate that's higher than the double-taxation of dividends.

      Dividends are property income, which tends to be taxed higher than income from work in Canada. It really depends on the situation. Someone who owns a small corporation with modest profits (ie, under half a million dollars) and pays himself dividends will probably pay less tax than someone getting a similar salary, while a professional with a high salary getting dividends from shares in Telus will probably pay more tax.

    • cont'd

      I've done tax returns for a few hundred people with income trust investments, and I wouldn't classify them as a "reliable monthly income stream". "Good chance to lose your investment", perhaps. The first general rule of income trusts was that they were a legal loophole which would someday be closed.

      Income trusts were very complicated creations. In my opinion, the only way to really to understand them is to have spent several years doing business tax returns and financial statements. Very few financial advisors have this kind of background, and gave out a lot of bad advice on income trusts. (And most other investment matters, IMHO).

      • So it is allright for BC Provoncial Employees Pension Fund to own these and not be subject to the 32 % tax. Harpers own Pension Plan owns these, The Arabs and South Koreans are picking these up at Rock bottom prices. You must be Flaherty because there is no proof of tax leakage !!!!!!! So it's allright for Pension Plans to own these but not retail investors. Where is you head, I know…….

    • cont'd

      The sudden drop in value of Mr. Popovich's income trusts after Mr. Flaherty's decision to tax them was 100% the result of public scaremongering (and absolute refusal to inform themselves) by the MSM and zero percent from actual financial implications of the decision. The new tax only applied to income trusts that were created AFTER the new law came into effect, so none of Mr. Popovich's investments were effected.

      As an aside, corporate profits are only taxed when they are not invested in future growth, and only double-taxed when paid out as dividends to individuals or non-Canadian companies. Most perception of corporate double-taxation comes out of American media. There is very little of it in Canada.

      • YSP

        Good to hear from you , however , you need to get your facts straight.

        Mr Flaherty`s trust tax decision did have a direct effect on my portfolio & any others who owned them & who held on to them as an investment from that point forward.

        There was a radical price drop immediately after the announcement which was scare driven no doubt—the subsequent drop in unit price post-scare was due to the factoring in of the 31.5% tax to start in 2011 on trust distribution payouts to the owners.

        You ideas on double taxation are out in left field as any dividends within tax sheltered accounts are double taxed , once at source & once again as straight interest income when the sheltered account is collapsed—that is what made income trusts so attractive to the small senior investor as it half-ways eliminated this unfair personal rip-off by the gov`t.

        YSP , if you have any more concerns , please feel free to contact me.

        Dr Mike Popovich
        Rodney Ont

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