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Wednesday’s Financial Post ran the 5th instalment of the 7-part series I’ve been writing on The Eternal Truths of Personal Finance.
I originally headlined this one with a title that’s long been familiar to personal finance writers and investors: Be an owner, not a loaner, which is to say emphasize stocks over bonds. The headline in the print edition today (FP5) reads Eternal Truth No. 5: Embrace Risk, pay less tax.
When I posted this blog, there was no online version available, so I took the liberty of posting my original draft, which may vary from the edited version in the paper. Here’s the link to the first in the series, and nearby should be links to at least instalments two to five.
Eternal Truth # 5: Be an owner, not a loaner
By Jonathan Chevreau
Savings is by definition the difference between the amount of money you earn and the amount you spend. To create a surplus, obviously you must spend less than you earn. If there’s a deficit and you spend more than you make, you have the problem of debt, which we handled in Truth #3. But even if you live frugally within your means and pay yourself first, you’re not going to get rich just leaving your savings in a bank account paying almost zero interest.
Since the financial crisis hit in 2008, interest rates have hovered near generational lows and the pittance that’s paid in bank accounts, or even GICs or money market funds, is unlikely even to match the rate of inflation. If inflation is running at 2% a year and you’re receiving 1% in interest, you’re not even treading water: you’re losing money: the “real” (that is, after-inflation) return is minus 1%.
Own a business, or a diversified equity portfolio
Even worse, what little interest you are being paid will be taxed at your highest marginal rate, just like the last dollar you earn on your salary, or any bonuses. Rather than loaning your money out through bonds, GICs, savings bonds and the like, you need to embrace the concept of being an owner, rather than a loaner. In practice, being an owner means owning stocks of quality businesses, or equity mutual funds or equity exchange-traded funds providing exposure to a whole basket of such enterprises. Of course, you can also start your own business and be an owner of a bricks-and-mortar enterprise or one based on the web. But for the purposes of this article, we’ll assume you’re going to go the diversified ownership route of investing in equities.
A basic axiom of investing (it could even be our 8th truth!) is that risk and return are related. Being a loaner supposedly entails low risk, so the expected return is low. Being an owner of a business or equities entails more risk, so the expected return should be higher.
One route would be to focus on quality dividend-paying stocks: these days you can find utilities, banks, pharmaceutical and telecommunications stocks paying dividends anywhere between 3 and 5%, which is a far sight better than the 1% you might get loaning your money out. Stocks also address two big long-term risks facing retirees: inflation and longevity. Over time, you can expect dividend hikes that keep pace or beat inflation, plus growth of the underlying capital.
More favourable tax treatment of dividends and capital gains
The bonus is that this higher dividend income is taxed more preferentially than the interest income that goes to loaners. Qualifying Canadian corporations will generate the dividend tax credit that – depending on your income, tax bracket and province of residence – will provide a return roughly double interest income and on an after-tax basis, as much as triple. Of course, this applies primarily to taxable or “non-registered” investment accounts. The dividend tax credit is wasted if the stock is held in an RRSP or TFSA. US dividends are taxed like interest for Canadian investors, so they are best held in an RRSP.
The other benefit of being an owner rather than a loaner is capital gains. When you’re an owner, you can win twice: once on the dividend (if any) and again if the stock rises in value over the time you own it. For starters, only half your capital gains are taxed (that’s called the 50% inclusion rate) so you should be able to keep roughly three quarters of the return from the capital gains. Secondly, you can avoid even the partial tax as long as you buy and hold the stock without taking profits and “crystallizing” the gain. And third, even if you do choose to take partial profits, you may be able to neutralize the tax consequences by selling an equal amount of another stock on which you’ve suffered capital losses.
Capital losses, you say? Yes Virginia, the downside of all this ownership potential is that you must be prepared from time to time for an investment in any given stock to lose value. Capital gains and even steady dividends are not guaranteed the way a GIC “guarantees” an annual payout of 1 or 2%. (guaranteed to lose to inflation, I’d say!)
Depending on how much risk and volatility you can stomach, you’ll want to work with a financial advisor to determine an appropriate mix of stocks and debt instruments. This is called asset allocation, which is really just a fancy way of telling you how much you should be an owner, and how much a loaner.
