It is very important not to tie your investment returns to a particular index. An index does not have emotions, nor does it have goals, taxes to pay, an income to generate, or a nest egg to save.
Understanding how your financial plans integrate with your investment portfolio is of the utmost importance.
Below is Worldsource Financial Management’s latest newsletter. It offers some tips and strategies you should consider regarding your financial plans.
At the end of the third quarter the S&P/TSX composite index had increased by 5.31% (CPMS) on a year to date basis while the S&P500 was up 23.83% (TD Securities & Bloomberg).
While there is always a desire to try to measure investment performance, doing so against a market index may not be the most appropriate measure. This is because an index is a representation, rather than a benchmark. The representation the index makes is only possible without the factors that govern our day to day existence. Unlike most investors the index feels no fear nor does it have taxes to pay. The index does not put children through school, never buys a house, and never plans to retire. An index, in short, makes a poor proxy for the goals of an individual investor over any period of time, be it short or long-term.
The factors that drive individual investment decisions are myriad; dividend payment, dividend growth, earnings per share, quality of earnings, the industry, and broadly that each of those individual criteria are improving each day. An oft quoted maxim from popular investment icon Warren Buffet is “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” If indeed the market were closed for five years, it would be impossible to produce a value for the S&P 500, or the TSX, or any index for that matter.
Arguably investor’s should use vastly different criteria to measure their personal portfolio returns than index returns. Instead of asking what the index did, investors should ask if the portfolio matches their personal objectives, and if the economies that the portfolio is exposed to, are better off today than yesterday?
Investors are not the only individuals that can use benchmarks to evaluate performance, as voters can also create benchmarks to evaluate their government’s performance. In creating political benchmarks voters can prioritize matters that are important to them such as taxes, social services, healthcare, humanitarian aid, deficit reduction, and how they worked with other government parties to better the economy and country.
While Canada’s federal government has of late been mired in spending scandals a more interesting study from a benchmarking standpoint might be that of the US government, who on Thursday October 17, came to an agreement on a deal to reopen the government and raise the debt ceiling. Without this deal, it was a very real possibility that the U.S. would default on its debt, which likely would have caused a financial catastrophe.
While nothing more than a short term fix, this deal does fund the government through January 15, and raises the debt ceiling until February 7. The reality is this deal did not fix any of the underlying issues. No progress was made on the budget, tax reform and the Tea Party’s view on Obamacare. It was 16 days of posturing and bickering and accomplished nothing.
With focus now back squarely on the economy until early in the new year, American voters must now ask themselves if the government is performing the way they want it to and if it not then just as with portfolio evaluation they must reassess their options.
Did You Know That?
Registered Retirement Savings Plans (RSPs) are still one of the best ways to save! Not only do you still receive a tax deduction for your contribution but investment income earned is tax deferred. Yes that is tax deferred, which means that eventually Canada Revenue Agency will be in a position to collect taxes owed as opposed to income that is tax free, such as that withdrawn from a Tax Free Savings Account (TFSA). While the benefits of investing far outweigh the disadvantages of investing in an RSP there are ways to maximize this plan types usage, such as:
Estate Planning with an RSP
RSPs allow you to name a beneficiary which means that upon death the value of the RSP flows to your beneficiary (if named) as opposed to your estate. This allows for the minimization of the cost of probate (but not income taxes unless certain beneficiaries are named to the plan). Make sure that the beneficiaries you have designated are up to date and reflect your intentions.
Income splitting allows spouses to split up to 50% of income generated from eligible pension sources and is a strategy that can be advantageously employed when spouses are in different tax brackets. While generally not applicable to RSP withdrawals, those over the age of 65 may want to convert all or a portion of their RSP to a Registered Retirement Income Fund (RIF), which is eligible for pension splitting. Another RSP income splitting strategy is the spousal RSP. Spouses who use this strategy should be aware of the income attribution rules when making withdrawals. These attribution rules will apply when the non contributing spouse makes a withdrawal within three years of a contribution having been made and will result in a tax liability for the contributing spouse.
Timing of Withdrawals
One of the major drawbacks of registered plans such as RSPs and RIFs is that withdrawals are fully taxable to the recipient as income. This income either on its own or in combination with other sources of income can result in the claw back of income tested government benefits such as Old Age Security and tax credits such as the age credit. As a result, timing withdrawals that coincide with years where your tax bracket will be lower than in future years is a worthwhile activity.
Delay claiming your RSP contribution
Perhaps the biggest advantage that RSP contributions provide is the immediate tax savings associated with the RSP deduction. However, don’t be in a hurry to claim it in the year that you make the contribution as you can delay claiming your RSP deduction to a year where you are in a higher tax bracket, thus increasing the tax savings associated with your contribution.
There is no question that RSP plans are a valuable savings tool, however through proper planning they can be even more effective.