1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #58!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points:
For our first topic, since we are approaching the end of 2023, we will discuss year-end tax planning strategies for individual investors.
And for our next topic, we will chat with Raymond Kerzerho, PWL’s Senior Researcher, about his latest blog regarding Canada’s major pension plans.
Enjoy!
2) YEAR-EN TAX PLANNING FOR INVESTORS:
François Doyon La Rochelle: Well, it’s that time of the year again to cover Year-end Tax Planning Strategies for Investors in Capital Market Securities. It has been an annual tradition for us on the Podcast. We want to remind our Listeners that the insights and advice we will be sharing will be general in nature. We would need a more detailed understanding of an investor’s tax and financial situation to give specific recommendations. Listeners should consult their tax advisors, portfolio managers, and financial planners for personalized recommendations.
James Parkyn: Francois, I want to remind our listeners That when we talk about Tax, we adopt the Optimizing Mindset which is a very different concept than minimizing your taxes. By Optimize we mean you need to think not just about the current tax year but how your assets will evolve over the longer term and how you will need to plan your current and/or future retirement income withdrawals tax effectively.
I have often highlighted that Investors should consider they are building assets in 3 Buckets:
Registered Accounts like RRSPs or RRIFs (Pre-tax monies) on the left bucket.
Investment Holding Company for Entrepreneurs (Pre-tax Monies) on the right bucket.
TFSA and Personal taxable accounts (Tax Paid Monies): in the middle bucket.
François Doyon La Rochelle: As a reminder to our Listeners, ideally, you want to pay for your groceries with the middle bucket. We often have Retiree prospects that come to us, and they have no funds accumulated in the middle bucket.
Or even worse they arrive at age 71/72 with all their assets in a multi-million-dollar RRSP or RRIF and no money in the other two buckets.
James Parkyn: That is a great point, Francois. So where to start for YETP? I will break it down into four topics for our Listeners:
How to trade smartly to optimize taxable capital gains or losses.
Actions that need to be taken before year-end Dec 31, 2023
New contributions limits in 2023 for RRSPs the TFSA and the new FHSA.
Major changes proposed regarding the Alternative Minimum tax rules that will apply in 2024.
François Doyon La Rochelle: The first planning topic is about how to trade smartly to optimize taxable capital gains or losses in your taxable accounts. You will need to know your 2023 history of Capital Gains and Losses: Start with getting the Realized Capital Gains and Losses Report for YTD 2023 for your taxable accounts. For your Holding Company, the Realized Gains & Losses Report should be based on the company's Fiscal Year End.
James Parkyn: Our clients who have been with us for many years, have benefited from the Deferral power of the Passive Strategies where we optimized the realization of Capital Gains on the Equity side of the Portfolio. But I remind our Listeners that Investment Decisions must take precedence over tax considerations.
François Doyon La Rochelle: I agree James. This means getting back to the engineering of your Portfolio. It’s always important to make sure that your current asset allocation is in line with your long-term target asset allocation. The main reason for rebalancing is to bring your portfolio back to its long-term target asset allocation. In a rising Stock Market, if you don’t rebalance your portfolio, you will always end up with a higher percentage of your portfolio in equities therefore with a riskier more volatile portfolio. It’s always better to rebalance your portfolio regularly and to take profits off the table instead of waiting for a market sell-off to do it for you.
James Parkyn: So François, where do you start the rebalancing process?
François Doyon La Rochelle: Well, I would advise our Listeners to consider four things before trading in their portfolios:
Beware of the Superficial Loss Rules
Can you carry back losses realized in 2023 to the 3 prior years.
Don’t forget currency impact on sale of a security held in a foreign currency.
Be mindful of the last trading day for settlement in 2023 which is December 27th.
James Parkyn: The tax rule is any losses you have not used in the current year can be carried back 3 years or carried forward indefinitely. To be able to use a loss in the current year the trade must settle prior to year-end. Remember to avoid the loss being considered “superficial” it is important that you or an affiliated individual don’t repurchase an identical position 30 days before or after the sale.
François Doyon La Rochelle: You should always start your rebalancing process in your registered accounts because selling the position that have gained will not have any tax consequences. By contrast, rebalancing in a taxable account may trigger a capital gain and taxes payable. For investors that need to make their annual RRIF withdrawal before year-end, take the opportunity of this rebalancing exercise to raise the cash for your withdrawal.
James Parkyn: Investors also need to be on the lookout for ETF and mutual funds year-end capital gains distributions, normally this occurs in December. These distributions are the result of fund managers selling some of their holdings during the year and if you hold your ETF or mutual fund in a taxable account you will have to pay taxes on these distributions.
François Doyon La Rochelle: The thing with year-end capital gains distribution, is that contrary to monthly or quarterly distributions that are paid in cash, the capital gains distributed in December are paid as a reinvested distribution, so no cash is distributed to you. For an investor who holds the position in non-registered or taxable accounts, taxes will need to be paid even if you haven’t received any cash.
James Parkyn: Passively managed ETFs and mutual funds don’t usually distribute large year-end capital gains, but it is always a good idea to look at your ETF or mutual fund providers’ website in November since estimates of annual capital gains are published.
François Doyon La Rochelle: In some cases, if the fund is distributing a large capital gain it could make sense to sell it to avoid the distribution. Before you go ahead and sell your position make sure you are not triggering an even larger gain on your transaction. Also, if you are implementing a portfolio close to year-end you may want to wait for the ex-dividend date before buying into a fund that will make a capital gains distribution.
So, James, now let’s talk about planning ideas regarding the registered accounts: RRSPs, TFSAs, RESPs, and the new FHSA.
James Parkyn: François, I will start with RRSP’s.
The current year's maximum RRSP contribution room is $30,780. Listeners can find their RRSP room on their 2022 Federal Notice of Assessment (NOA). This number will include unused contribution rooms carried forward from prior years.
The 2024 maximum RRSP contribution room will be $31,560. for those Listeners who like to make early bird contributions in January.
For Business Owners consider declaring a T4 salary of at least $175,333 by December 31, 2023. This will create the maximum RRSP contribution room of $31,560 in 2024.
If you have turned 71 in 2023, you must convert your RRSP to a RRIF and you have until December 31 to do so. But don’t forget to make any final contributions to your RRSP before converting it.
François Doyon La Rochelle: What do you have to share about TFSA’s?
James Parkyn: For TFSA there are a lot of planning points:
The TFSA dollar limit for 2023 is $6,500 but there is no deadline for making a TFSA contribution. The unused contribution room is carried forward. The CRA has announced the limit for 2024 has been increased to $7,000. Best to make your contribution as early as possible in January 2024,
For listeners who have not maximized their TFSA since 2009, you should check online with the CRA website to confirm your contribution room. The maximum room since 2009 is $88,000 in 2023 if you haven’t previously contributed to a TFSA.
Be careful, however, if you have withdrawn funds from your TFSA in 2023, you must wait for 2024 to recontribute the amount withdrawn.
If you are planning a TFSA withdrawal in early 2024, consider withdrawing the funds before December 31st, 2023, so you would not have to wait until 2025 to re-contribute.
François Doyon La Rochelle: Next up, is the new First Home Savings Account. We covered this topic in our Podcast #52 published earlier this year.
James Parkyn: For FHSAs, there are a lot of planning points:
First off you must verify if you qualify to open an FHSA. You can visit the CRA’s online website to make sure you meet the requirements.
In 2023, your contribution cannot exceed $8,000 as it is the first year the plan is available. You can claim a tax deduction for contributions within this limit, in 2023 (or a future year if not claimed previously). Unlike RRSPs, contributions you make within the first 60 days of 2024 cannot be deducted in 2023.
The new FHSA rules are complicated and as this plan is new, we are still discovering new details as we address each situation.
François Doyon La Rochelle: Let's talk about RESP’s. We also covered this topic in our recent Podcast #56.
James Parkyn: I will summarize the key end-of-year RESP planning strategies.
RESP contributions are subject to a $5,000 limit or $2,500 for the current year and $2,500 for one catch-up year. If you have less than seven years before your beneficiary child turns 17 and haven’t maximized RESP contributions, consider contributing by December 31 because otherwise, you will not be able to claim the maximum of $7,200 in Federal government grants.
The federal government has increased the maximum Education Assistance Payments (EAP) that can be taken in the first 13 weeks of post-secondary education to $8,000 (previously $5,000) for full-time students and $4,000 (previously $2,500) for part-time students.
If your child is a RESP beneficiary and stopped attending a post-secondary educational institution in 2023, EAPs can only be paid out for up to six months after the student has left the school. You may, therefore, wish to consider making a final EAP withdrawal for that beneficiary before year-end especially as they may have to pay much higher taxes in 2024 with a full year of employment income.
François Doyon La Rochelle: The Federal government has made changes to the Alternative Minimum Tax (AMT) that will start in 2024. James, could you briefly summarize how AMT works?
James Parkyn: First of all, AMT affects very few taxpayers.
The new rules will apply to taxpayers who generate more than $173,000 in taxable income. The changes will significantly impact high-income earners who make large charitable donations.
The Alternative Minimum Tax (AMT) system imposes a minimum level of tax on taxpayers who claim certain tax deductions, exemptions, or credits to reduce the tax that they owe to very low levels. Under the AMT system, there is a parallel tax calculation that allows fewer deductions, exemptions, and credits than under the regular income tax calculation. If the amount of tax calculated under the AMT system is more than the amount of tax owing under the regular tax system, the difference owing is the AMT payable for the year.
François Doyon La Rochelle: So James, what are the changes for 2024?
James Parkyn: The changes for 2024 include raising the AMT rate to 20%, increasing the AMT exemption to 173,000$ in taxable income, and broadening the AMT base by limiting certain exemptions, deductions, and credits that reduce taxes.
François Doyon La Rochelle: What should taxpayers do before Dec 31st?
James Parkyn: For many high-income earners, gifting publicly traded securities with accrued capital gains “in-kind” to a registered charity or a foundation is a favorite year-end tax planning strategy. Given the new AMT rules, Taxpayers who plan large donations in 2024, should consider making those donations before Dec 31st.
François Doyon La Rochelle: This year-end tax planning strategy is attractive as you get a tax receipt for the fair market value of the security being donated.
James Parkyn: I would add François, one of the key tax benefits of gifting publicly traded securities with large, accrued capital gains “in-kind” is it also eliminates capital gains tax.
François Doyon La Rochelle: Yes, we do this for many clients. Taxpayers should plan gifting in-kind well before year-end, to allow for sufficient time to execute this type of donation. James, it would be helpful for our listeners to know the new AMT rules and how it impacts large donations.
James Parkyn: If a taxpayer plans to make significant charitable donations, there are two significant changes as a result of the new AMT rules. As of 2024, only 50% of the donation tax credit would be allowed when calculating AMT (compared to 100% allowed currently). Secondly, if you make in-kind donations of publicly listed securities, 30% of the capital gain on those securities will be included when calculating AMT. Currently, none of the capital gains is included.
François Doyon La Rochelle: We recommend that our listeners consult with their tax advisor well before year end to determine strategies that may help to reduce their exposure to AMT.
Are there any other tax moves that you recommend taking before the year-end?
James Parkyn: Yes, I have a few:
Pay investment expenses to claim a tax deduction or credit in 2023. This includes interest paid on money borrowed for investing and investment counseling fees incurred for managing non-registered accounts.
For our Retiree listeners, the dreaded OAS clawback is always a big concern. You need to make sure that your income does not exceed the recovery thresholds. Taxpayers must repay their OAS at the rate of 15% of 2023 net income over $86,912. The entire OAS amount must be repaid if a taxpayer has a net income over $142,609 for taxpayers between ages 65 to 74 or if a taxpayer has a net income over $148,179 and is age 75 or up. This is a means test that also amounts to a form of double taxation. Because OAS is an individual benefit, it is not impacted by family income but instead is clawed back based on individual taxable income.
François Doyon La Rochelle: What about tax instalments for 2023? What is your advice for our listeners?
James Parkyn: The big question is: have you made enough quarterly tax installments in 2023?
The final tax installments are due on December 15th. Now that you have a pretty good idea of your total income for 2023, you can decide if you need to pay the final installment. A word of caution: If you have not made the amounts requested and you end up owing significant tax on April 30th, you may be subject to penalty interest for underpaid amounts. It is always safer to pay the amount requested unless there are major changes to your 2023 income vs the prior 2022.
François Doyon La Rochelle: Another point that our Listeners need to take note of is that interest income will be much higher in 2023 compared to 2022. Even though you made all your tax installments in 2023 as requested, you may still end up owing a lot more tax comes next April 30th.
James Parkyn: Finally, we have said many times before in our Podcast that tax Planning should be done all year long. Do not wait until year-end to optimize your taxes.
François Doyon La Rochelle: Indeed James, and I hope they do. I believe we have covered a lot of ground and hopefully, our Listeners will find this update very useful. I also want to remind our Listener that our comments and Advice on this Podcast are generic in nature and all our Listeners should consult their tax and financial advisors.
3) UPDATE ON CANADA’S MAJOR PENSION PLANS:
Francois Doyon La Rochelle: Now for our next topic, we welcome RAYMOND KERZÉRHO, who’s PWL’s Senior Researcher, and we will discuss his latest blog regarding Canada’s major pension plans.
Good morning, Ray, we are pleased to have you back on the podcast.
Raymond Kerzérho: Good morning, François, I’m very pleased to be back.
François Doyon La Rochelle: Ray, you are here today to discuss your latest blog post, which was recently published on PWL Capital’s website entitled “Twelve Observations About the Big Canadian Pension Managers and Eight Takeaways for Individual Investors”. Over the years at PWL, you have often published internal research papers on this topic. Now that you have shared this latest blog with the public, can you tell us why reviewing these large pension fund managers has been a worthwhile exercise for our clients and what our listeners should take away?
Raymond Kerzérho: The “Big Nine” pension managers are at the leading edge of investment management. Although they don’t disclose everything they do, their annual reports provide a lot of insight. I think anyone who has an interest in money management should look at what they do and ask themselves: Is there something in what they do that would make sense to apply for my portfolio? Some things do, and some others don’t. That’s the whole point of my post.
James Parkyn: Yes, Ray, I can say that I agree. The research you have done for us over the years on large Canadian pension funds has been very useful and has helped us, as portfolio managers, in our thinking to improve the engineering of our client’s portfolios. Our large Canadian pension funds are truly world-class organizations.
As you have quoted Ray, in your introduction, the World Bank in their 2017 paper about the Canadian pension fund model has said and I quote “Canada is home to some of the world's most admired and successful public pension organizations.” I think that, as a Canadian and a future retiree, we can be very proud that our political leaders had the foresight to create these funds.
François Doyon La Rochelle: I agree James. Now coming back to Ray’s blog. Ray, you make twelve observations about large pension fund managers in your blog you call them the Big Nine, can you tell our audience what you mean by that?
Raymond Kerzérho: Sure, The Big Nine are the nine largest Canadian public pension managers, they are responsible for assets totaling $2.1 trillion. This is an amount similar to the combined amounts managed by the Canadian mutual fund and ETF industries.
François Doyon La Rochelle: So, within that group Ray of nine you would find the CPP Investments Board that manages the Canadian Pension Plan and also the Caisse de Dépot et Placement du Québec. So Ray, within your twelve observations which ones are the most relevant for our audience?
Raymond Kerzérho: There are three things I’d like to discuss here.
First, the Big Nine are incredibly successful. A paper published in 2021 by a group of researchers found that Canadian pension funds trounce their global peers. The Big Nine annual reports confirm that: they all beat their benchmark over ten years. That’s quite an outstanding achievement!
François Doyon La Rochelle: Yes, that’s quite a big achievement. Apart from having a lot of success and beating their benchmarks what else did you observe?
Raymond Kerzérho: The second thing that struck me was these managers have transformed their portfolios in the last decade or so. During the 2010s, the world went through a period of extremely low bond yields. In response to that environment, most of these managers have drastically reduced their bond allocations in favor of riskier alternatives such as private loans, private real estate, and infrastructure.
Lastly, some of these organizations can be expensive to run. Collectively, they have cost 15 billion dollars last year. Costs may run from 0.44% or 44 basis points to almost one percent of their assets. But the most expensive managers are not necessarily the best. The manager that outperformed most over 10 years is also the cheapest. There’s a saying that “If you pay peanuts, you’ll get monkeys”. But it’s not what I see with the Big Nine: low cost and great results can go together.
James Parkyn: That’s an interesting observation Ray and it’s exactly in line with our thinking that lower fees, increase the chances of long-term investment success. Now from your observations, can you share with our listeners the key takeaways for retail investors?
Raymond Kerzérho: The Big Nine… they do a few things that investors should emulate. They diversify globally, and they keep cash allocations to a minimum. These are things everyone can do competently and efficiently with low-cost ETFs. Another thing I noticed is they don’t have big allocations to hedge funds and they avoid crypto. I agree with that, and I wouldn’t touch any of these products.
François Doyon La Rochelle: Ray, are there things that you would not copy from the Big Nine?
Raymond Kerzérho: Yes absolutely, I wouldn’t copy from the Big Nine, things such as replacing bonds with private real estate and infrastructure. These big managers invest a lot in private assets, and they have the professional staff to do all the required complex due diligence and manage these assets at costs that, frankly, very few can match.
François Doyon La Rochelle: Ray, can you give our audience an example of how the Big Nine reduces the cost of private investments?
Raymond Kerzérho: The Big Nine uses several strategies to reduce the cost of managing the funds. For example, they co-invest with private equity firms. That is very technical, so to help make it a little bit clearer, what they do is they go to private equity firms and say: “OK, we’ll invest in your fund, and we’ll pay you fees for that. But you will also allow us to invest directly in the portfolio companies. However, on these direct participations, we won’t pay any fees.”
François Doyon La Rochelle: Ray what we see more and more is private investment funds directly marketed to retail investors. What do you think?
Raymond Kerzérho: Investors should beware, the costs are brutal. My advice is: “Don’t do that with your portfolio. The high fees are going to enrich the fund managers at your expense. Stick with broadly diversified low-cost stock and bond ETFs, and you’ll likely get better long-term results.”
James Parkyn: Ray, I have noticed in your blog that the returns generated by these Big Nine pension managers have been significantly better than what has been available in public capital markets. Can you highlight the reasons why?
Raymond Kerzérho: First, as I said earlier, the Big Nine outperforms almost everyone else, and this includes retail investors.
Secondly, returns depend on how you value assets. Between a third and a half of the Big Nine portfolio is invested in private assets. These private assets don’t trade publicly so you need to hire outside experts to value them. Regular stock and bond portfolios are valued daily by the markets. The markets and experts often come to very different conclusions.
I’ll give you an example:
Last year, the S&P global real estate index returned -19%; that’s the return according to the stock market. At the same time, the Big Nine's global real estate holdings returned, on average, +5%. Two different valuation methodologies resulted in very different returns. I’m not saying the experts are wrong, I’m just saying that if both portfolios were valued with the same methodology, their returns would likely be much closer.
François Doyon La Rochelle: Yes, in financial jargon we say one is marked to market, which means that it's priced buy the markets daily versus the other that is not marked to market. And I also think it’s fair to say that these large allocations are in illiquid investments and that they should generate higher returns.
Raymond Kerzérho: That’s correct François. Now the third and last factor I would like to mention is big managers can handle a lot more risk than individuals. As individuals, we have a limited lifespan, and we invest only for our account. The Big pension managers pool the money of millions of Canadians, and they are going to be there like… forever. Of course, they can handle a lot of risk! They take more risk, and they get higher returns.
James Parkyn: This makes total sense, risks and returns are related therefore if you are taking more risk, you should be compensated with higher returns. Thank you very much Ray for joining us today. It’s always wonderful listening to your latest thoughts on smart investing.
Raymond Kerzérho: Thank you for having me, it was my pleasure.
François Doyon La Rochelle: Yes, thank you, Ray, we hope we will have you back on our podcast soon. In the meantime, I invite our listeners to consult your blog post on PWL Capital’s website and we will add a link to your blog with the podcast.
1) CONCLUSION:
François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge.
James Parkyn: You are welcome, Francois.
François Doyon La Rochelle: That’s it for episode #58 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
Also, if you like our podcast, please share it when with family and friends and if you have not subscribed to it, please do.
Again, thank you for tuning in and please join us for our next episode to be released on January 18th next year. In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon!