Our cold snap last week was a reminder of the wintry blasts that lie in store for us. It's time to get the snow tires on the car, and make sure that the house and grounds are prepared. I enjoy the 4-season climate that we have in Calgary, but why does summer have to be so short, and why does winter have to stick around so long? Carmen with Kelly-Anne & Zoe

Carmen and Mike at the Theatre

Registered Education Savings Plan

We set up the RESP so that mom Kelly-Anne is the designated subscriber and we all contribute to her plan. You could set up a plan where you have more control, if that's what you wanted.

Just to reiterate, the federal government contributes 20% of contributions, up to a maximum of $500/yr. If you do the math, the feds maximize their "donation" when the subscribers invest $2500/yr. The Alberta government also throws in $500 when the RESP is first established, and $100 when the child reaches 8, 11 and 14 years of age.

Tax Free Savings Account

The TFSA is a structure, not an investment. A wide variety of securities can be placed within the framework of a TFSA.

In short, the TFSA allows any Canadian over the age of 18 to place up to $5,000 per year into the account, and never, ever, have to pay tax on the growth of those funds. As an added bonus, unused TFSA contribution room accumulates, just like unused RRSP contribution room. If you have never put money into a TFSA, you now have $15,000 of unused contribution room for every household member. That number will rise to $20,000 on Jan 1.

• Saving for a major purchase - interest on funds in a TFSA savings account won't get taxed;
• Retiree - required withdrawals from a RRIF that are in excess of the funds needed for living can be placed in the TFSA and not attract further taxation;
• Income splitting - TFSA is a way to get $5,000/yr into a low-income spouse's hands.
• High-income Individuals - while there is no tax deduction, the investments in the TFSA won't get hit by tax on the investment returns.
• Withdrawals from a TFSA won't affect means-tested benefits like the GIS or health care subsidy; or create problems like the OAS clawback.
• Low-income students - deposit any extra funds (or funds from parents) into a TFSA, then withdraw the money in higher-earning years for deposit into an RRSP.

You can put all manner of investment into a TFSA. There are two extremes:

• The banks are pushing the idea that TFSAs should be used as a low-interest savings account. This is appropriate if you plan to withdraw the money in short order for another purpose, but it is not suitable for longer-term savings.
• At the other extreme, some investors have chosen to use their TFSA as the place in which to purchase their most risky speculations, for example junior mining or oil stocks. The idea is that if they have a 10-bagger, the gain will all be tax-free.

My clients have tended to use a more conservative strategy. We have invested in income-producing mutual funds. Each month, we take the distribution and place it in a money market fund. This strategy separates the "income" component from the "growth" component of the mutual fund.

We can't predict what the market value of the mutual fund is going to be over the year; that's up to the vagaries of Mr. Market. However, the money accumulating in the money market fund is showing us that the fund is doing its job of spinning off income.

Our favoured supplier is offering RRSP loans at Prime!
That's only 3% right now!

RRSP Loan

Here's the math. Suppose you take out a $6,000 RRSP loan in January, with the proceeds placed into a money market fund so that there is no market risk. If you're in the 33% tax bracket, this will give you a $2,000 tax refund, which you'll use to pay down the loan principal.

You have chosen a 1-year amortization of the loan, and have deferred payments until June. By that time you'll have received your tax refund and paid down the loan, so the outstanding principal is only $4,000. You make 8 monthly payments of $508.16 and a small 9th payment, and you've retired the loan in time for the following January.

Flow-Through Shares

Flow-throughs give you the same tax benefit as an RRSP: you can deduct the cost of the investment against your taxable income.

A Mining flow-through gives you an additional 15% tax credit - that's a direct reduction on the taxes that you have to pay! Put the two benefits together, and your after-tax cost is only 50¢ on the dollar, into a sector that is very depressed this year.

Does an investment in junior mining stocks make financial sense without the tax breaks? I can't guarantee future profit, but here is how we've done over the past few years:

• In 2005, the partnership dissolved after only 6 months with a $10,000 investment worth $13,932.
• In 2006, the partnership dissolved after only 7 months with a $10,000 investment worth $11,320.
• In 2007, the partnership dissolved after 23 months with a $10,000 investment worth $3,769.
• In 2008, the partnership dissolved after only 6 months with a $10,000 investment worth $12,092.
• In 2009, the partnership dissolved after 14 months with a $10,000 investment worth $11,010.
• The 2010 partnership has not dissolved after 10 months.

As we come to the end of 2011, we know that junior mining shares trade at very low valuations. If you believe in "buy low, sell high", this could be an opportune time to invest in a flow-through.

That's mining. What about Energy? An energy flow-through allows you to deduct the cost of the investment against your taxable income, but without the extra 15% tax credit. Still not bad, for a sector that folks in Alberta are familiar with. Despite the cries of the greenies, the world still needs oil and supplies are getting harder to find all the time.

We have energy flow-throughs, flow-throughs that are divided 50/50 between Mining and Energy, and even a flow-through that invests in Energy gross overriding royalties. The latter has no chance of making a pre-tax profit, but does give stable after-tax benefits.

Please give me a call if you'd like to discuss how to reduce your tax bill!

Retirement Income

Table 1

Secure Income Sources
The Old Age Security (OAS) and Canada Pension Plan (CPP) form the base of most retirees' income. A dual-income couple, in which both husband and wife qualified for maximum CPP, would be eligible for as much as $35,684/yr from government benefits.

Some employees might be lucky enough to have a defined benefit pension plan from their place of work.

Guaranteed Investment Income
If there is a gap between the "necessities of life" (however you define them) and your baseline pension income, you can fill the gap using investments that provide a guaranteed lifetime income. Guaranteed investments come in 2 flavours: annuities and GRIPs. Both are offered by life insurance companies, and are ultimately backed by Assuris, the insurance industry equivalent of CDIC.

An indexed life annuity gives you a worry-free income for the rest of your life. For a male aged 65, $100,000 will purchase an annual income of around $6,150, indexed at 2% annually. There is no estate value. If that is a concern, you may want an insured annuity, which is essentially permanent life insurance piggy-backed on top of the annuity.

A Guaranteed Retirement Income Portfolio (GRIP) is suitable for those who want a floor under their retirement income, but also want to participate should the markets boom. A GRIP is a structure. It can contain a variety of asset types, but you generally want to maximize the equity exposure in order to be in position to get raises in the event of a stock market boom.

A GRIP (started at age 65) guarantees a minimum 5% return on the invested capital, so $100,000 placed into a GRIP will generate an income of at least $5000/yr for your lifetime.

Registered Investment Income
With your necessities of daily living covered off by pension income and guaranteed investment income, let's now look at the two most common retirement income structures: the Registered Retirement Income Fund (RRIF) and the Life Income Fund (LIF).

You can hold a variety of investments within a RRIF or LIF. You can even hold a GRIP within a RRIF or LIF! You do NOT have to change your investments when you convert your RRSP into a RRIF, or a LIRA into a LIF. The only change is the requirement to take income.

Many retirees worry about outliving their investments. I recommend to clients that they limit RRIF/LIF withdrawals to the greater of 6% of Jan 1 capital or the previous year's withdrawal level.

Once you reach age 71, the required minimum withdrawal is more than 6%, so I recommend that the "excess" be reinvested in a TFSA, where the money can grow tax-free, and is available if needed without any tax implications.

Where We Are

The situation in Europe may be worse. Greece and Italy have lost their sovereignty. Elected governments have had to step aside for new management controlled by the European Union in Brussels. It is in effect a coup d'etat by foreign bureaucrats. Financial monitors have been installed in key ministries in both countries. The job of the new masters will be to protect foreign bondholders. They will not be responsible to the local citizens.

There are incessant calls for the European Central Bank to step in and purchase sovereign bonds in a massive way, despite the fact that this has been expressly forbidden within the ECB's articles of incorporation. Germany has been particularly steadfast in opposition. The German people remember the inter-war Weimar hyperinflation, and more recently went through the difficulty of reunification. They do not want a repeat on an even grander scale.

On the other side of the world the #2 economy, China, is trying to slow down its overheated economy. The Bank of China has made 7 interest rate increases over the past year. The latest data indicate that China's economy is slowing; the question is whether it will be a "soft landing" or if the slowdown overshoots on the downside. Still, it's a nice problem to have compared to the US or Europe.

Bond, stock and currency markets have reacted to the macro-economic news in their usual way. Bond yields have gone down, making bond prices go up (prices move in a direction opposite to yields). Stock markets have retreated from their April highs, but with great volatility. The Canadian dollar has fallen relative to the US greenback and the Euro, and resource prices, oil in particular, have dropped in anticipation of lower demand.

Table 2 indicates how the various market indexes performed up to the end of October.

Table 2
2011 YTD Returns to 31 October

MSCI: Morgan Stanley - Capital International
EAFE: Europe, Australia & Far East
Globe: Globe & Mail

Health Care remains up +0.5%, and Real Estate is down -1.4%. After a strong start, Financial Services has fallen in response to the European banking problems. It is down -12.2% on the year.

Worries about weakness in the developed world have affected the Emerging Markets, which are down -13.4% on the year.

Most of my clients have diversified portfolios. I use the Globe Canadian Neutral Balanced Index as my primary benchmark. It was down -2.2% at the end of October.

Where We're Heading

"Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits ...It is precisely the fickle nature of confidence, including its dependence on the public's expectation of future events, which makes it so difficult to predict the timing of debt crises."

John Mauldin, in Endgame

In the meantime, businesses in Canada and the US are doing very well. Corporate profits and dividends (Chart 1) are still growing and are on track for peak earnings a couple of years down the road.

Chart 1

The US labour market may be a lot better than is commonly acknowledged. I've shown in previous letters that my two leading indicators for employment - temporary agencies and manufacturing overtime hours - are both back to pre-recession levels.

There are also a lot of leading economic indicators that indicate that the US economy is improving. Even housing seems to have stabilized, albeit at a low level. Don't count the US down and out!

Currency
The linkage between the USD/CAD exchange rate and the WTI oil price broke in the last month, as the problems in Europe have overwhelmed the currency markets. Currency traders have run en masse to the perceived safety of the greenback.

As I write this letter, the exchange rate is $0.9523, while the oil price would imply the rate should be $1.044. The last time that there was such a spread between the actual and theoretical value of the looney was in March 2008, when the 2008-09 financial crisis was just beginning.

Interest Rates
The US Federal Reserve Bank has confirmed that it plans to keep interest rates at or close to zero into 2013. Given the close alignment between Canada and the US, that means that Canadian interest rates will remain at rock-bottom levels for the next year and a half too.

In any event, investors who want to be buyers of bonds or GICs can expect extremely low interest rates for the foreseeable future, all across the maturity spectrum. The only way to get more yield is to take on more risk, either through the corporate bond market, or through dividend-paying stocks. This is not good if you are a risk-averse pensioner trying to live off RRIF investment returns.

Conversely, I'd say that now could be an excellent time to take on debt for a worthwhile purpose such as an RRSP top-up loan or home improvement, since we know that interest rates are going to remain low for a long time.

… the Canadian and US stock markets have the potential
for 25% gains over the next couple of years.

Investment Policy

• Governments may have to become serious about handling their debt and deficit issues. If they do, global economic activity will slow;
• Money-printing by central banks is not inflationary as long as "velocity of money" remains low;
• Commodity prices will be weak in a slow economy;
• The Canadian stock market outperforms the US market during times of rising commodity prices, and underperforms when commodity prices are weak;
• The Canadian looney is a petro-currency, and its value is dependent upon the oil price;
• Gold has retained its purchasing power over time, while paper currencies have lost value;
• Interest rates will remain at rock-bottom levels for the next year and a half;
• Corporate profits remain solid and are on track for another 25% gain over the next 2 years;
• Corporate cash positions are strong so companies will be able to weather economic turbulence.

We do not know what the future might bring, so we need to spread our wealth among stocks, bonds, real estate and commodities, and across currencies and countries.

I continue to believe that pension-type balanced funds should form the core of most people's retirement portfolios. They have served the test of time. As I mentioned in a previous section, a balanced portfolio should be able to support a 6% withdrawal rate without running out of money.

I realize that the media are doing a wonderful job of scaring people. It is easy to defer making any investments into your retirement plan or TFSA "until things look more certain". That's a mistake. As Sir John Templeton once said:

The best time to invest is at the point of maximum pessimism.

Sir John Templeton

If you're still fearful, consider a GRIP that has a guaranteed minimum 5% return during the accumulation phase, or consider a dollar-cost averaging fund to ease your way into the market. Give me a call to discuss.

I'll close off this letter with yet another quote, this time from Jacob Fugger the Rich:

"Divide your fortune into four equal parts: stocks, real estate, bonds and gold. Be prepared to lose on one of them most of the time. During inflation you will lose on bonds and win on gold and real estate; during deflation you lose on real estate and win on bonds, while your stocks will see you through both periods."

Jacob Fugger the Rich (1459-1525)