Advisor’s Edge / advisor.ca – Page 2

A tax strategy about nothing

What Seinfeld can teach us about the value of staying the course

Like a lot of families, we’ve been doing things differently while social distancing during the pandemic. In addition to dusting off board games and semi-regular family walks, our latest streaming service has allowed us to catch up on classic TV, including Seinfeld.

More than three decades since it hit the air, there’s still something about the sitcom that came to be known as the show about nothing. That worked in the world of comedy, and may give us something to think about in the more serious world of portfolios.

I’m certainly not suggesting that investors set up portfolios once and ignore them thereafter. On the contrary, it’s imperative to be aware of economic developments — such as the market movements since the onset of Covid-19 — as well as any changes to the businesses behind individual securities.

Financial advisors are the source for this kind of information, reviewing with clients what’s relevant (including the effect on the investor’s appetite for risk) and deciding if adjustments are warranted. Those may include portfolio changes, behavioural changes, or both — or nothing at all.

The critical point is to resist the urge to make changes for the sake of change alone. The urge to just do something can be particularly harmful to a non-registered portfolio.

Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.

If those portfolio changes are based on a focused review, then the tax implications should not stand in the way of action. However, if the original portfolio continues to suit the investor’s planning needs, then a premature change not only drifts away from the plan but also compounds that diversion by triggering taxes unnecessarily.

A tale of two investors: Gerry & Jorgé

Consider sister and brother investors Gerry and Jorgé, 40 year-old fraternal twins saving for an elaborate trip together for their 50^th birthdays. Both have high incomes, so we’ll use a 50% marginal tax rate. Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18, but has since come back to $14. It pays no dividends.

Despite the recent price decline, Gerry leaves her investment alone. Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells.

With a fair market value of $14,000 and a $10,000 adjusted cost base, Jorgé realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.

A few months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.

Ten years later when it’s time to book the trip, VanDelayed is at $28.

Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.

With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.

Even though Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, putting him $750 behind Gerry. The amount lost would vary depending on the growth rates, but, as long as there was indeed growth, the difference would never come out to nothing — which is something to think about.

How medical symptom checkers can shine a light on robo-advice

The limits of expert systems

While running in the great outdoors this weekend, I was listening to the Skeptics Guide to the Universe podcast, which explores and de-bunks pseudo-scientific claims. It got me thinking about the delivery of financial advice, and automated advice in particular.

After discussing Covid-19, co-host Steven Novella, a medical doctor, went on to question the accuracy of online symptom checkers (SCs). In a recent blog post, he summarized the findings of an Australian study that evaluated the accuracy of 27 online SCs.

Novella characterized the study’s results as “pretty disappointing.” On average, the correct diagnosis was listed first 36% of the time.

Not bad at first blush to hit it on the head more than one-third of the time, but the correct diagnosis was only listed among the top 10 possible diagnoses 58% of the time. For practical purposes, that means the correct diagnosis was missed 42% of the time, as most patients likely don’t look beyond the top 10.

More interesting to me, though, were the potential reasons why the diagnoses were so poor.

Parallels with automated financial advice

As the panellists shared their thoughts, I couldn’t help but see the parallels with automated tools in the personal finance and investment fields. These include do-it-yourself online brokerages and robo-advisors that offer online investment portfolios, but also advisors’ own tools: from the reference sources that clients never see, to side-by-side processes, to that solo interaction between the client and the evaluation tool.

Wherever the technology lies on that spectrum, it can’t be a proxy for the advisor.

As with the doctor-patient relationship, a financial advisor has to understand the client in order to deliver personalized advice. The less the advisor interacts with the client, the more difficult it is to deliver.

And even with the benefit of direct contact, it remains the advisor’s responsibility to apply and explain the tools and their output so the client’s interests are adequately served.

Points to ponder

Here are some of the podcast panellists’ thoughts on symptom checkers, and how I see them applying to financial advice:

Quality of input

Patients are often not very good at describing symptoms. People may say numbness when they mean weakness, or they may treat the two as the same, Novella said.

A client may use similarly imprecise language to describe their personal goals or their feelings about risk.

Alternatively, a client may adopt words offered by the document they’re filling out or the platform they’re using without appreciating nuances. Absent the advisor probing further, the premises for a client’s action (or inaction) may not properly reflect their intentions.

People come to you with a narrative

Both medical patients and financial clients can be biased, frequently responding with their relative feelings anchored on recent experiences. One has to ask questions in multiple ways to deconstruct the objective facts from the narrative, and then reconstruct those facts in the medical or financial arena where they are to be applied.

It’s a dynamic investigative process that takes a lot of insight into how people think and communicate. A focused professional can then use this knowledge to move the relationship forward.

Body language

An experienced physician reads all the signs, including the patient’s body language. Advisors can observe a client’s posture and tone of voice, and how a couple interacts — things you don’t experience through checks in boxes or even the most eloquent text summaries.

Triage function

This is the “Do I go to the hospital?” moment. The SCs reviewed in the Australian study scored 49% on this measure, though they erred more on the side of sending people when it wasn’t necessary.

While there’s no life or death counterpart in financial advice, the accumulated harm of unverified guidance could make it difficult for someone to recover should problems materialize in later years.

The “why” of the output

It’s not enough to produce an output and expect that it will speak for itself. Newer SCs that use artificial intelligence give reasons for why they predict certain things, as well as how sure they are about the output provided.

That’s a large part of the financial advisor’s value to the client: explaining where things come from and where they are headed. It’s a check against the quality and thoroughness of the inputs that led to the output, and an opportunity to reinforce the client’s confidence and commitment to the plan you are creating together.

As a final point, it should be noted that SCs have no common regulation, if any at all. Comparatively, there is plenty of regulation in the financial field, and compliance departments help advisors stay vigilant and within boundaries.

Still, financial tools can be very complex. It’s incumbent on advisors to fully understand what is at their disposal so that digital platforms are used as tools of the advisor, and not in place of the advisor

Emergency fund advice in a time of crisis

Whether clients are accessing funds or inspired to save for the next crisis, here’s what they need to know

In the sci-fi classic Ender’s Game, gifted children play simulated battle games with aliens at the edge of the universe, until (spoiler alert) the title character realizes during an especially intense sequence that he’s in the midst of the real thing, and everything to that point has just been practice.

When clients last contemplated their emergency funds, a global pandemic would have been well at the perimeter of possibilities. And yet, here we are.

So, those with an emergency fund may now be asking: How do I use it? And those who don’t have one — but are fortunate enough to still be in regular earning mode — should be thinking about how and when they would use an emergency fund as they begin saving.

Regular budgeting addresses recurring expenses, plus reserves for periodic capital outlays. Insurance is for the extreme where there are remote-risk/high-peril events. An emergency fund lies between.

The fund allows a client to sustain their household in a time of crisis — whether that’s an unexpected injury, job loss or a global pandemic — while expenses continue to pile up.

How and when they should use the emergency fund is a function of how they define “emergency.” Encourage clients to commit to the above definition when they begin saving so it’s preserved for truly pressing needs — like now— and not depleted on emotional wants.

Using an emergency fund

Like Ender’s alien battle, we’re no longer practicing. It’s time for clients to actively monitor and log their spending. This will help them manage the current situation, and learn for future planning. This is how clients should use their emergency funds now:

The immediate non-negotiable needs are food and safety. Clients can cut down on these expenses by shopping brand-consciously, reducing cost-per-unit by buying in (reasonable) volume, and being vigilant about portioning and waste.
Shelter costs like rent/mortgage and utilities are next. Federal government income supports should help indirectly, and housing-specific relief may be on its way, whether from government, lenders, landlords or a combination. Whatever form and amount this takes, clients must understand why this is a top priority: interest and penalties on short/skipped payments will compound the emotional and money stress the very next month, and further impair a client’s finances in the recovery time to follow.
Dispensing with all discretionaries may not be practical as clients hunker down for the coming days and weeks, but they should be selective about the prudent pleasures they choose.
Suspend luxuries and harbour no regrets. Encourage clients to keep their focus on the present, comforted that their conscientious actions today will improve their prospects tomorrow.
Counsel clients to log where their money is coming from and where it’s going, so they can manage within their changing means. That’s a good habit in good times, and critical in a crisis. Many have a bit more time these days to form the habit.

Building a fund for future crises

The emergency fund’s purpose, now or after the Covid-19 crisis, is to have money accessible for a specific number of months. But how many? Clients should start by planning for the most likely emergency: an employment gap.

Based on the client’s industry and where they work, how long do they think it would take to get re-situated? An estimate provides a goal for the number of months of funding.

Second, while losing income is painful, what matters most in an emergency is spending. Help clients review their bank and credit statements from the last year, taking out anything truly extraordinary and deducting items they may be able to defer for a few months. Divide the total by 12 for a monthly average, and multiply by the chosen number of months. This is the client’s lower limit (the upper limit includes those deferred items).

Third, set up a regular deposit to the fund, ideally aligned with the pay cycle. Clients should assign a percentage or dollar amount they can commit to, even if it’s a small figure.

Now, the gut check: divide the emergency fund target by the weekly deposit commitment. This will show how long your client needs to get there. If they feel a knot forming in their abdomen, they may want to bump their commitment. But that unease must be balanced against the discomfort from the current budgetary sacrifice in order to arrive at a manageable medium.

As a kicker, an oft-suggested alternative to an emergency fund is a line of credit at the ready with a bank or credit union. For some people, taking on debt at a time of financial stress may be an uncomfortable proposition. Still, establishing a line of credit can be an effective complement to an emergency fund, knowing that it will be there to fill the gap if an emergency hits before the fund reaches its accumulation target.

Registered or non-registered?

Your RRSP is not an appropriate choice as an emergency fund. With withholding tax as much as 30%, clients will have to take a higher gross amount to net to what they need. And if the withholding is less than the actual tax due, they’ll be scrambling to come up with cash at filing time next year. Withdrawing from an RRSP for an emergency also puts retirement at risk. Keep these two needs separated.

On the other hand, the TFSA is well suited for emergency needs. With no tax to deplete withdrawals, budgeting is much more transparent. Withdrawals are also entitled to the usual re-contribution credit, which can be both the motivation and target for replenishment once the emergency passes.