Jason Heath: Beware of financial advice that is biased or even outright wrong
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There is no shortage of financial advice for Canadians to decipher, whether it comes from financial professionals, social media influencers or well-meaning brothers-in-law. Some of it is good, some of it is biased and some of it is outright wrong. Here are four of the biggest myths that I encounter in the world of personal finance.
Lots of investors and advisers focus on stocks that pay dividends. It is important to understand the way a dividend works. When a company earns a profit, the board of directors can declare a dividend and pay some of that profit to investors. Many companies pay consistent dividends each quarter because they have stable businesses that are profitable but may have limited growth potential. Limited growth potential means they can only reinvest so much in their business so they might as well pay out some of their profit to investors as dividends.
By comparison, another company that is in a growth mode might decide to retain their profit and use it to grow their business, make it more profitable, and make the share price go higher. They may also pay dividends, and as they grow, they may reach a point where they start to raise their dividends if they cannot reinvest all their profit in further growth.
Imagine you own a stock worth $100 that earns a five per cent profit. It might pay out $5 as a dividend or it might keep that $5 to grow the business. If it pays you out a $5 dividend, you have a stock worth $100 and $5 in cash, or $105 in total.
Now, imagine another stock worth $100 that earns the same five per cent profit. Instead, the board of directors feels they can grow their profit even more by keeping the $5 profit and reinvesting it. If that $5 stays in the business, the stock may be worth $105.
This is an overly simplistic example, but the point is dividends are not magical. Two companies that are equally profitable may provide a similar total return to investors over the long run. One may do so with dividends and the other with capital growth. But it is less likely a company can pay a high dividend and also grow as much as a company that is reinvesting in growing their stock price.
High dividend stocks in Canada tend to be from a handful of sectors like banks, telecommunication companies and utility companies. Financials, communication services and utilities make up less than one-quarter of the S&P 500 — that gives you a sense of how undiversified a Canadian dividend portfolio can be for an investor.
There are way worse investment options than a portfolio of Canadian banks. But the point is dividends may not be as special as they are cracked up to be. And in a taxable investment account, they trigger tax at a higher rate than the tax payable on a capital gain from stock price growth, and result in annual tax instead of deferred tax on a capital gain.
Stocks are risky
To say that stocks are risky is a blanket statement. It is like saying that ice is cold. Over time, ice melts and becomes water. When boiled, water becomes hot.
Stocks can be risky over the short term. The S&P 500 has lost money about 25 per cent of the time over one-year periods going back to 1926. Day to day, the S&P 500 goes down about 44 per cent of the time. Over a five-year period, the S&P 500 has had positive returns 88 per cent of the time. An investor with a diversified portfolio of U.S. stocks, Canadian stocks, international stocks and bonds would reduce their risk of losing money over the medium term and certainly over the long term even more.
Stocks can be riskier depending upon how you buy them. If you put all your money into a junior oil stock, there is a greater chance your investment goes boom or bust. An undiversified portfolio can be very risky. If you own 20 or more stocks from different industries or geographies, either directly or through an exchange traded fund or mutual fund, your risk drops dramatically.
Over the long run, stocks can be a great way to grow wealth and avoid the risk that inflation erodes your purchasing power and causes you to outlive your savings.
CPP will not be there so apply early
The Canada Pension Plan provides retirement pensions for contributors who can start their pensions between ages 60 and 70. Some people think the CPP will not be sustainable and that may influence them to start their pension early.
The 2023 annual report from the board of trustees for the U.S. equivalent of CPP, Social Security, warned that funds may run short by 2034 and require a 20 per cent decrease in the benefits paid to pensioners without congressional intervention.
The CPP is managed by the Canada Pension Plan Investment Board, a Crown corporation that holds CPP funds from contributors for paying pensions. The Chief Actuary of Canada does an independent triennial report on the CPP and most recently said it should be sustainable for the next 75 years.
The report for the 2019 to 2020 fiscal year stated that “the ratio of assets to the following year’s expenditures is projected to increase rapidly until 2025 and then decrease after that, reaching a level of about 26 by 2075 and remaining at that level up to 2095.” That means money in the CPP fund is projected to be more than 26 times as much as will be withdrawn the following year until the time that today’s 25-year-olds are pushing 100.
I have written extensively on the benefits of deferring CPP, as it rises for every year you delay starting it, much like deferring withdrawals from an investment account. A recipient only needs to live to their mid-80s to receive more lifetime income, even after adjusting for the time value of money, compared to starting earlier. Since 50 per cent of 65-year-olds will live to age 90, most pensioners should defer their CPP, yet only four per cent of women and five per cent of men chose to defer their CPP to age 70 in 2022.
CPP applicants may have their own reasons for applying early, but it certainly should not be because they are scared the pension may run dry.
Always max out your RRSP
If your income is below $50,000, you should probably not contribute to a registered retirement savings plan (RRSP). That is, unless you have an employer matching contributions. The higher your income is above $50,000, the more beneficial an RRSP contribution becomes.
Some people think you should contribute to an RRSP because it gives you a tax refund and saves you tax. That is not true. An RRSP contribution defers tax. It defers tax today on your contribution and you will pay tax back in the future on your withdrawals. By no later than age 72, you have to start taking withdrawals from your RRSP. When you die, your remaining RRSP balance is fully taxable. If you leave your RRSP to your spouse, it can remain tax deferred until their death.
If you contribute to your RRSP when you are in a low 20 per cent tax bracket earning income under $50,000, imagine contributing $10,000. You save $2,000 of tax and deposit that refund to your tax-free savings account (TFSA). You invest the $12,000 between the two accounts for 10 years at four per cent. After 10 years, the RRSP is worth $14,802 and the TFSA is worth $2,960. If you are still in a 20 per cent tax bracket, and withdraw the full amount from your RRSP, it is only $11,842 after tax. And the TFSA withdrawal has no tax, so it is still $2,960. That is a total withdrawal of $14,802 that could be taken from the two accounts.
If instead you put the whole $10,000 into your TFSA, it would grow to $14,802 over 10 years at four per cent. You could withdraw the same $14,802 as the combined RRSP/TFSA example. The problem? Most people spend their tax refund from their RRSP contribution. If you do, that makes you worse off compared to investing the same money in your TFSA (or paying down debt instead, for that matter).
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Furthermore, some retirees end up in higher tax brackets in retirement when they are in the lowest tax bracket during their working years. Especially when you consider means-tested benefits that they could get if they were taking TFSA withdrawals instead of taxable RRSP withdrawals. And in the case of a couple, if one spouse dies young, the survivor has all income on one tax return and RRSP withdrawals could be at a higher tax rate than the tax saved on the contribution. If both spouses die young, RRSPs could be taxable at over 50 per cent for an estate.
Beware of these personal finance myths, some of which may be perpetuated by professionals, let alone others. The more you can develop your knowledge and try to apply it to your own situation, the better financial decisions you will be able to make.
Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever. He can be reached at firstname.lastname@example.org.
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