Tax Free Savings Accounts are being peddled with what you’d have to call near-religious zeal by banks, credit unions, insurance companies and investment dealers. They are all hungry for your cash, your fees, and a chance to develop some new business in a very tough time for the economy.
The TFSA concept is the essence of simplicity. If you are over 18 and a resident of Canada, you put tax paid money into a TFSA. Money earned on that investment is tax free, as the name suggests. The annual limit is $5,000 and you can invest it as you like, take out money with no further tax, and open up TFSA room on a dollar for dollar basis with every withdrawal. If you make, say, five per cent on your money in 2009 — $250 — and if you are in a 30 per cent average tax bracket, you will save $75. Nice, but not earth-shaking.
The TFSA promises to be easy to use. It will not subject the investor to a tax on withdrawal, as RRSPs do. But TFSAs will not generate a tax refund either.
Yet they have an interesting symmetry in comparison to RRSPs. The RRSP can save you say 30 per cent on the refund when you contribute and the TFSA can save you a similar amount, which is really just your tax bracket, when you withdraw.
WHAT SHOULD YOU BUY WITH YOUR TFSA?
The problem with the TFSA concept today is the low and chancy returns that are available in today’s stock and bond markets. In spite of these crummy returns, the vendors of these accounts are pushing them as though they were juicy sources of yield — as they were in the late 1990s. In truth, their yields are so low that you can safely pass them by and invest another year. It is enough to open a TFSA this year in order to establish your contribution space.
The problem for the investor is to manage investment risk and return. Let’s take a look at a few relationships:
—Canadian money market funds produced an average return of 2.00 per cent in calendar 2008 after charging their investors average management fees of 1.18 per cent. Looked at another way, the funds charge 37 per cent of their total return to clients for picking treasury bills, bankers’ acceptances and some corporate IOUs called commercial paper. That’s outrageous.
—But the 2.00 per cent, which is going to be less in 2009, looks good compared to the 1.25 per cent interest payable on this year’s crop of Canada Savings Bonds. CSBs have no fees and they are among the safest investments one can find. Only Government of Canada bonds match them for security. But the return is ridiculous. You’d have to wait for nearly 58 years to double your money before tax at this rate. If the CSBs are held outside of RRSPs or the TFSA and are subject to a 30 per cent tax, you would have to wait for 82 years to double your money. That’s preposterous.
—A three-year GIC pays about 3.3 per cent these days. There are no fees when you buy them from banks and credit unions. Your money will double in 22 years at this rate provided that growth is not taxed. That’s a little better, but interest rates are likely to rise in less than three years. You are tying up your money for a longer time than you must.
—Mutual funds focused on Canadian stocks lost 30.7 per cent in 2008. They could show some recovery this year or continue their downward path. The average management expense fee charged on these funds is 2.4 per cent. If you hold the fund for 10 years as the market recovers, as it is likely to do within the decade, your fees will be 24 per cent. The funds may gain or lose value, though over periods of 10 or more years, the odds favour a positive return. But paying 24 per cent for a roll of the dice is scandalous.
—So what’s the right thing to do with TFSAs? To get a good balance of gains and fees, consider bond investments. Government bonds pay low single digits, so they are for security rather than growth. But corporate bonds offer yields to maturity that capture both interest and price rises in a range from perhaps six per cent to as much as 12 per cent and in exceptional cases to 20 per cent.
There is no return without some kind of risk, and investment grade corporate bonds, to be sure, do have some chance of default. Some subordinated bank bonds pay 11 per cent to maturity, others as much as 20 per cent to the time when the issuer may call them in.
Banks are all in much the same difficulty these days, so buying bonds from three banks is not really adequate diversification. If corporate bonds are your choice, you’d want some bank bonds perhaps, some utilities, some pipelines, and perhaps some government-issued mortgage bonds just for security.
You could also pick a bond fund with a mix of corporate and government issues.
There are many good choices in these blended funds. Corporate bonds had hard times in 2008, for they lost ground as investors panicked over default fears. The fears were overblown and corporate bonds have recovered some of their fear driven discount. Yet with yields double and even triple those of government bonds, an investor should give them and funds that hold them a look. You can find what bonds funds hold by going to
their management fees and try to balance returns with the cost of getting those returns. Exchange traded bond funds are available in a wide variety of asset mixes with management fees that range from 0.15 per cent to about 0.60 per cent. Buy an exchange traded fund through a discount broker and your trade costs may be well under 0.50 per cent. But remember this: a bond fund with a management fee that equals or exceeds its probable returns — and there are many of them — is a beast without a purpose. The best bond funds are the cheapest. The pricey ones only work if the manager’s mandate is to shop for complex global bonds that compound currency problems with economics and credit analysis.
Assume that you put some money into a blend of corporate bonds that yields seven per cent to maturity. In four years, you’ll have 28 per cent of yield and perhaps another 10 to 20 per cent on prices rising as credit fears subside. That would be 30 to 35 per cent, enough to make up for losses on Canadian stock funds.
This is not a play on stocks bouncing off a bottom. Corporate bonds with, say, 10 years to maturity can produce large gains as credit conditions improve. In a sense, they are ripe for picking in the near term before business recovers. Call them an investment for the moment. They offer security, countercyclical gains, and good returns. You need to buy several issues from various companies in different industries or even a couple of good funds with corporate bonds. May the profit be with you.
Andrew Allentuck’s new book, When Can I Retire? Planning Your Financial Life After Work, was recently published by Penguin Canada.