“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.”
– Vladimir Lenin
Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.
Not too many years ago, there was a type of investor commonly called a “GIC Refugee”. The rates on Guaranteed Investment Certificates (GICs) once upon a time generated a decent income; but the interest rates on renewal kept dropping. Dropping rates meant dropping income which eventually meant they would have to eat into their capital to maintain their living standard. So GIC Refugees eventually stopped renewing their GICs and moved their money into stocks and bonds seeking higher returns.
Although bonds suffered some of the same problems as GICs, one could get higher interest through extending the term to maturity or by buying non-government guaranteed company bonds that are little more than IOUs. But in an environment where interest rates were declining and the economy was doing well, not only did you get the decent interest, but you also benefitted from the rise in price of the bonds.
Declining interest rates not only helped lift bonds, but companies that borrow also found their interest expense dropped and their after-tax income rise. This has helped to support stock prices which have climbed to record highs and now trade at historically high P/Es. And declining interest rates have also helped people to afford to borrow more to buy real estate. So we’ve been seeing massive asset bubbles in real estate.
Our government has pursued a fiscal path of running deficits to support the economy which may continue for several more years. And we’ve seen our Canadian dollar shrink in value against the US dollar.
To help partially fund government deficits, we’ve also been seeing income taxes rise – directly on those of high income and indirectly through limiting deductions, credits and exemptions for businesses and on estates and Trusts. Of course, there have been some tax reductions for the lower income to middle class to make income tax rises more politically palatable.
The longer term impact of higher income taxes have yet to be felt. But we may see individuals and businesses moving south where tax rates are in process of declining from levels near 35% down to 20%. As a result, their taxes may be quite lower both corporately and personally than in Canada. And if a US border adjustment tax gets implemented, the Canadian economy could be at risk of going into a recession.
A drain of people and businesses to the US may result in relatively less job creation in Canada and less innovation or incentive to create products that can lift our economy.
Rising inflation, rising interest rates, and rising taxes are dangers to meeting our living needs; especially those that are retired. Highly priced and volatile stock markets, like what we experienced in 2008/09, can be extremely scary. There are no longer any worthwhile guarantees and no safe place to put most of your retirement nest egg. It certainly makes my job of investing to help meet my clients living needs more challenging.
The traditional asset allocation view of holding a diversified portfolio of stocks and bonds to manage risk and develop a more stable return doesn’t hold the way it used to. That’s because bonds now do not generate enough income to help meet client needs and bonds are at risk to rising interest rates. So in a rising interest rate environment, bonds may generate inadequate income or suffer losses in value.
Mathematics on Bond Returns
Let’s open up the newspaper and look at 5 Year GICs – see: http://www.financialpost.com/personal-finance/rates/gic-annual.html. The more competitive GIC rates are about 2.25%. Assuming you buy the GIC and hold it in your personal investment account, the interest is going to be taxable.
Assuming you live in British Columbia, your combined BC and Federal personal marginal tax rates are summarized below:
Let’s make an assumption you are in the $45,916 to $77,797 bracket having a marginal tax rate of 28.2%.
Now let’s take a look at Canadian inflation:
As an aside, the actual level of inflation you are experiencing is likely much higher than this unless the goods and services you buy are similar and in similar proportions to those used by Statistics Canada to measure inflation. But let’s assume future inflation of 2.0%.
So if you have $100 invested in an annual pay GIC held personally, your situation is as follows:
As a result, you’ve lost purchasing power and will continue to do so as your capital remains locked away for another four years of the five year term. Buying investments that lose purchasing power is a bad investment.
So GICs are a money losing proposition if held personally. But what if they are held in a Tax Free Savings Account or an RRSP/RRIF? Trouble is that they provide a return similar to inflation so you’re not gaining much.
How about bonds? They are generating low returns like GICs see: http://www.financialpost.com/markets/data/bonds-canadian.html. To make matters worse, long term bonds are subject to a high level of risk in a rising interest rate environment. To appreciate this risk, the table below shows that the longer the term to maturity, the greater the potential loss in rising interest rates:
But what about high yield bonds (“poorer quality loans”)? The trouble with these is that in a poor economic environment, like if we go into a recession, the rate of defaults may rise. Cyclical businesses and poor quality businesses can see their credit quality decline with declines in revenues and/or earnings. Similarly, going to emerging market bond funds may result in high volatility and expose you to currency devaluation risks.
There is a solution to helping retired GIC Refugees achieve a livable standard of living. But one cannot ignore the huge risks now faced. The search for good risk-adjusted returns in a low interest and highly priced market is that much more difficult today. And we must be vigilant as ever in diversifying your investments to control risk. Lastly, we must consider your cash needs through time to develop the right asset mix so you are not exposed to an unnecessarily high level of risk. This is not the time for the uneducated or inexperienced investor. The risk of getting it wrong can be a loss of a good chunk of your life savings – that means a lower achievable future retirement living standard.
If you are interested in working with an experienced investment adviser to help you navigate these tough times, please call me, Steve Nyvik, at (604) 288-2083 Extension 2 or email me at: Steve@lycosasset.com.