Recent discussions on the WP website revolving around the pros and cons of embedded compensation have gotten quite heated. A British Columbia advisor presents an interesting hypothesis. 

The Canadian Securities Administrators is currently studying embedded compensation and other sales charges. It’s possible regulators will ban trailer fees at some point in the future.

In an interview with WP, veteran financial advisor Harley Lockhart, past chair of Advocis and advisor at Quail Ridge Financial in B.C., said he’s baffled by the suggestion the industry should move to ban commissions, calling it neither credible or justifiable.

Lockhart believes any such prohibition on embedded commissions would cost consumers and is nothing more than a legacy move for OSC Chair Howard Wetston.

“It’s not a credible move and I think Howard is doing this because he wants to cement his legacy,” said Lockhart. “He wants to look good for the committee, he has a huge vested interest in making this happen and it’s going to cost consumers. It’s going to cost jobs. A significant number of advisors will be out of business because of this and it’s just a poor strategy in my mind.”

The U.K., South Africa and Australia took the investment industry by storm when they decided to ban commission-based selling and the idea that Canada would follow suit is drawing the ire of Lockhart and other advisors who feel they’d be unfairly targeted by the new regulations.

For those unfamiliar with the history of this very controversial subject, it began with a discussion published by the CSA in December 2012 that sought feedback from all the stakeholders in the industry about reforming compensation on the sale of mutual funds.

Lockhart argues the move could cost more than 25,000 jobs and the loss of advisors who won’t be ready or willing to make the switch to a fee-based service model.

“We’ll probably see a 25 per cent drop in the amount of advisors we have in Canada and there’s no reason for it,” said Lockhart. “What’s this going to do to the economy? All of those people being beat out of the business and I think that’s the attitude.”

Still, others such as advisor Jason Pereira thinks industry professionals will simply have to adapt to the changes and evolve with the times.

The senior financial consultant at the Bennett-March and IPC Investment Corp said the move is a necessary one because of the amount of abuse and mismanagement that can occur with commissions.

“I’ve heard a lot of stories from clients who come to find that advisors were making more than they expected and I think that’s driven some of them to a fee-based advisor,” said Pereira. “There are more of us in the market now and with all the different service models – robo advisors – there’s an opportunity create a new market.”

He added that there will be significant challenges but said the impact shouldn’t be too severe and commission-based advisors will need to step up their game to thrive in a fee-based system.

Longevity risks, combined with a shrinking working population, are causing enormous shockwaves in the pension system.

My wife is the Ontario Teachers Pension Plan’s worst nightmare.

She started working as a teacher full-time at age 24, and under the current pension formula, she’s due to retire at the ripe old age of 53. Sure, that’s early, but what makes her the OTPP’s worst nightmare is another number: her life expectancy. Her grandmother passed away a few years ago, aged 100 years and 6 months.

If my wife lives as long as her grandmother did, she’ll have worked for 29 years and been retired for more than 47—and collect 1.6 years of pension income for every one year of contributions.

Longevity risks, combined with a shrinking working population, are causing enormous shockwaves in the pension system: bankruptcies in the U.S., reform in many countries and, recently, protests in Montreal. How did we get here?

The Bismarckian Trap

The first modern public pension was established by German chancellor Otto von Bismarck in 1889. An 1881 letter from Germany’s emperor, William the First, to parliament, reveals the pension was designed to provide guaranteed income to “those who are disabled from work by age and invalidity have a well-grounded claim to care from the state. ”

That pension was not meant to let someone sail off into the sunset and play golf. Quite the opposite: it was meant to take care of people who were unable to work due to the physical stresses of age, which the Germans figured would likely happen after age 70. (The pension age was changed to 65
in 1916.)

The German model is often cited as the template for other state and private pensions that caught on around the world. But the model contained one fatal flaw: it pegged retirement age at 65.

According to researcher Patrick Liedtke, in 1881, a German man could expect to live 35.6 years and a German woman, 38.4. Even discounting for high infant mortality, few people ever collected on Otto’s promise. But today, the World Bank puts German life expectancy at 81 for someone born in 2012.

By making retirement age fixed, instead of flexible based on gains in life expectancy, pensions are being squeezed at both ends—they have to collect more money while members are working in order to pay out benefits longer.

If Otto had the foresight to make the retirement age flexible, Liedtke asked, when would people be retiring now? Try age 95! But since most people prefer certainty to ambiguity, politicians and pensions sponsors have been reluctant to move the retirement age from 65. As such, the number is sacred.

Cultural implications

When people take risks they’re insured against, it’s called moral hazard. Driving is a perfect example. Would we drive as fast or as inattentively if we didn’t have insurance, guard rails, air bags and snow tires? Likely not. Economists say we are consuming safety improvements by taking new risks—to the extent that our total risk level returns to where we were previously comfortable.

In the case of improving life expectancy and pensions, society has certainly consumed the improvements. Until recently, most nations had mandatory retirement ages, forcing productive members of society out of the workforce and eliminating their contributions to pension regimes. Modern Western society, thereby, created the concept of modern retirement with its world travel, golf and recreation. The ability to retire at age 65 has become a confirmation of success.

To make matters worse, we further consumed improvements by supporting the vision of early retirement, of which the cultural standard is 55—10 years earlier than the ever less-meaningful target of 65. And for the lucky ones, like my wife, some pensions permit even earlier retirement.

I place the blame for this in two places: first, with pensions for offering this benefit; and second, with our industry for encouraging the dream of retirement at 55. The end result: what was sustainable for Otto is highly unsustainable for the modern world.

Unseating the sacred number

How does this impact advisors?

1. We need to remind clients that retirement is changing.

When asked when they want to retire, most clients will either pick the date their pension starts, or default to 65. Even financial planning software defaults to this age. But, as clients approach 65, many are becoming less willing to retire, even if they’re on sound financial footing. They enjoy working because they like contributing to society, and their careers form part of their identities.

As age 65 approaches, ask clients whether they truly want to retire. Many may opt to consume more in their working years, pushing back retirement age by choice. And we may start to answer questions about how much less our clients can save in later years, not more. If clients choose to work beyond 65, that increases their savings years and, more importantly, reduces their number of retirement years. This results in a decreased need for annual savings and a smaller required nest egg. This leaves the client with a few choices: keep saving at the same rate and leave a bigger legacy, increase retirement consumption, or increase consumption both now and in retirement. I’m guessing most people would favour the last choice.’

2. We’ll have to tell clients not to count on their pensions.

That’s because pensions schemes are already changing. OAS is pushing its start date back to age 67. OTPP has gone from 100% indexed, to two-thirds indexed, to indexing as a best effort. Unlike before, teachers in Ontario can’t expect their pension to maintain their lifestyles. Indexing as a best effort could mean no indexing at all. To illustrate the impact, if one assumes a 3% rate of inflation, a retiree would see her real purchasing power decline almost 50% after 20 years if indexing doesn’t come to fruition. Advisors are going to have to help these people realize that their guaranteed retirement isn’t safe, so they’ll have to start saving more personally.

Quebec public pension members are being asked to increase contributions from 30% of the annual amount to 50%, and settle for a best-effort indexation benefit. So, advisors will have to consider only contractually vested benefits as likely to occur, and realize that most clients will have to work longer than expected.

If younger clients hold 55 or 65 sacred, they’ll have to increase prior savings in order to account for changes to the pension system’s retirement age, benefit level, benefit basis (best five years versus average five years) and indexation (which will likely disappear).

While eliminating pensions from your assumptions is extreme, you’ll need to encourage clients to build a larger nest egg. Clients should plan on retiring on not just what they need, but also a fair amount more than they need. How much more? Assuming a 3% rate of inflation, no indexing, a 5% after-tax rate of return and 20 to 30 years in retirement, an investor would have to save four to seven times what their annual pension benefit would be.

So, if someone retires with a $60,000 annual pension benefit, the present value of an indexation benefit is $240,000 to $420,000. While that isn’t the biggest mountain to climb in a lifetime, a person would have to save that on top of pension contributions.

The impact of fees on long-term performance is a common marketing theme among ETF and other low-fee providers.

It’s a valid consideration, because fees reduce total returns. But there’s another drag on performance that can have more impact: taxes.

A perfect world

What would happen in a world without taxes or fees? Let’s look at two different portfolios where income’s automatically reinvested:

• Bonds: $100,000 growing at 6%

• Stocks: $100,000 growing at 9% (6% capital appreciation, 3% dividend yield)

Over 20 years, each would grow as follows:

• Bonds: $320,713

• Stocks: $560,441

Fee drag

Let’s now consider the impact of two different fee scenarios: high and low.

High:

• Bond @ 1.80%: $227,695 ($93,018 total fee drag: 29%)

• Equity @ 2.50%: $352,364 ($208,077 total fee drag: 37%)

Low (cut both fees in half):

• Bond @ 0.90%: $270,429: ($50,284 total fee drag: 16%)

• Equity @ 1.25%: $444,985: ($135,626 total fee drag: 21%)

Because of compounding, halving fees doesn’t halve fee drag. Even small differences in a compound rate over a period as long as 20 years create disproportionate results.

Now let’s look at fee drag versus tax drag. There are three tax rates we need to consider: interest, dividends and capital gains.

Tax drag on fixed income

Interest earned on fixed income is taxable annually at the same rate as regular income. Consider two scenarios: high tax (50%) and low tax (25%). (These are close approximations of the upper and lower tax rates in several provinces.)

• 50% tax: $180,611 ($140,102 total tax drag: 44%)

• 25% tax: $241,171 ($111,193 total tax drag: 32%)

With interest income, the tax drag on performance is substantially worse than fee drag. In every possible combination, tax has a larger impact than fees:

• High Fee/High Tax: 29% versus 44%

• High Fee/Low Tax: 29% versus 32%

• Low Fee/High Tax: 16% versus 44%

• Low Fee/Low Tax: 16% versus 32%

Tax drag on equity

Consider these five variables when looking at the impact of tax on equity investing:

• capital appreciation rate;

• dividend yield;

• capital gains tax rate;

• dividend tax rate; and

• portfolio turnover ratio.

Return on equities consists of capital appreciation and dividends. We assume the after-tax amount is reinvested, as well as 6% capital appreciation and a 3% dividend yield.

Capital gains are easy to approximate. Given they are 50% taxable, we can assume half the rate used for fixed income. That means 25% for the high rate and 12.5% for the low.

It’s less straightforward with dividend income. Due to how taxes on eligible dividends in Canada are calculated and the fact that rates vary across provinces, the marginal tax rate on dividends is actually negative. For this analysis, we’ll again consider two rates: a high rate (33%) and a low rate (0% rather than negative).

These four tax rates still only lead to two different outcomes. Since someone at a high rate pays that rate for capital gains and dividends, there’s no need to consider any high and low combinations.

Turnover ratio has a significant impact on taxation. It represents the percentage of the portfolio that’s sold off to buy new investments in a given year. This has a massive impact on capital gains tax, which is only payable in the year the investment’s liquidated. So, the lower the turnover ratio, the fewer times capital gains tax is paid. That means the investment’s return can compound for longer without tax.

We’ll consider only the extremes: buy-and-hold (turnover ratio of 0%) and a highly active strategy (turnover ratio of 100%).

• High Turnover/High Tax: $353,027 ($207,414 total tax drag: 37%)

• High Turnover/Low Tax: $488,155 ($72,286 total tax drag: 13%)

• Low Turnover/High Tax: $398,241 ($162,200 total tax drag: 29%)

• Low Turnover/Low Tax: $502,886 ($57,555 total tax drag: 10%)

Key takeaways:

• Turnover has a greater impact than tax rates.

• High-bracket, high-turnover investors suffer tax drag that’s roughly equivalent to what high-fee investors face.

• High-bracket, low-turnover investors are better off than high-fee investors, and worse off than low-fee investors.

• Low-bracket investors suffer more from fee drag than tax drag.

We may conclude that equity investors are less tax sensitive than fee sensitive, especially when compared to fixed-income investors. It’s also important to note that high turnover is relatively rare in the managed-product world. Assuming the average mutual fund turnover rate is around 33%, odds are most investors experience tax drag higher than 10% to 13%, but much lower than 29% to 37%.

Implications

This is a simplified example. If you ran a more exhaustive analysis, you’d find the crossover point where taxes are worse than fees.

There’s much discussion in the media about fee drag, but there are other costs a good advisor can (for a fee) help minimize through effective planning. From advice on sheltered accounts to tax loss selling, advisors can help minimize or eliminate long-term losses from tax drag.

Pick up any article about personal finance and you’ll see the same story: Canadians are spending too much, saving too little and carrying too much debt. In other words, they need help.

That’s where advisors come in. However, all too often advisors focus on product and accounts such as RRSPs and TFSAs as a means of solving problems for clients.

Yet some of the most valuable advice I give has nothing to do with those products. It’s that taxes impact every financial allocation decision.

Changing perceptions

People refer to income, both employment and investment, in pretax terms. They say, “I make $75,000,” not, “I make $57,978 after tax ($75,000 after tax in Ontario).”

Makes sense. How many clients actually calculate after-tax income? Besides, $75,000 sounds better because it’s a higher number, and we all like knowing we make more—even if we keep less.

On the other hand, we look at expenses based on their nominal value, as in, “I paid $50 for that.”

If the expenses happen to be deductible or qualify for a tax credit, the average person usually knows it will actually cost them less than $50.

Now, let’s flip this on its head. What would you have to earn to pay that $50? The Ontario resident earning $75,000 has an average tax rate of 22.70% and would have to earn $64.68.

That’s kind of a depressing discovery, isn’t it? The point is, considering before—and after-tax amounts can help us allocate our money differently.

The true cost of debt

Interest rates are currently near all-time lows, which is great news for anyone with debt. But what is this debt really costing people?

The chart “Pretax carrying cost” (below) shows the pretax carrying cost of various interest rates across various average tax rates. We can see a few things from this chart:

• People with lower average tax rates have pretax carrying costs similar to the after-tax rate (as to be expected)

• The inverse is true for higher income earners. The pretax carrying cost of an 18% credit card is actually 25.71%. In dollar terms, in order to pay $18 of interest on a $100 balance, this person would have to earn $25.71, a full 43% more. Even a 3% rate turns into 4.29%.

To higher-income earners, this revelation can be rather shocking.

The subsequent reaction is typically, “Oh well, what can I do? I have to pay tax.” While this is true, it provides us with a new frame of mind for allocating funds.

In order to make those decisions, however, we have to consider the marginal tax rate. Why? The cost of debt using marginal rates can be seen in the chart “Cost of debt with marginal rates.” Looks a lot uglier, doesn’t it?

The folly of emergency funds

Most clients feel the need to have a cash cushion.This may be a few thousand dollars, or up to six months’ income. Typically this emergency fund sits in regular or high-interest savings accounts and earns up to 2%.

Meanwhile, clients carrying mortgages are paying at least 3% interest.On the surface, this looks like a 1%loss per year. But again, this compares before—and after-tax interest rates, which we’ve seen is like comparing apples to oranges.

Let’s say a client in a 40% marginal tax bracket has $10,000 sitting in an emergency fund and a mortgage at the same time. Based on the above rates, let’s see what happens when we consider the after-tax implications:

• After-tax rate of return from deposit: 1.2%

• Interest paid on debt: 3%

• Total Loss: 1.8%

Most clients would say that 1.8% is a small price to pay for peace of mind. But let’s look at it on a pretax basis:

• Pretax interest earned: 2%

• Pretax interest cost: 5%

• Total pretax loss: 3%

Now the client must consider, “If there were a new high-interest savings account paying me 5% instead of 2%, would I move my money?” Who wouldn’t? So the choice is clear: your clients should pay down debt instead of holding a pile of cash for an emergency that may never come.

But what if an emergency should occur? This is where proper planning comes in.

I encourage all clients who use their emergency funds to pay down their mortgages to take out a home equity line of credit to use in case of emergency. Sure, that means paying interest when an emergency happens. But in the meantime, you save interest. For more disciplined clients, more advanced mortgage solutions, like all-in-one line of credit mortgages, can make this even easier to implement.

True, the mortgage is a cost, not a return. But return increases your disposable income, and so does not paying interest.

Compound these savings over time and you’ll see how fast clients can reduce their debts.That simple $10,000 deposit could save as much as $10,699.07 in interest over the course of 25 years. That’s equivalent to 3% a year, or the same thing as earning 5% a year pretax in a 40% tax bracket.

Pretax carrying cost

Rate10.00%20.00%30.00%3%3.33%3.75%4.29%5%5.56%6.25%7.14%7%7.78%8.75%10.00%18%20.00%22.50%25.71%

Cost of debt with marginal rates

Rate30.00%40.00%50.00%3%4.29%5.00%6.00%5%7.14%8.33%10.00%7%10.00%11.67%14.00%18%25.71%30.00%36.00%