Worked Examples

 

Here are two worked examples to help you apply the lessons.

Long-term Adjustments: Petra

When Petra graduates from university she has some debt to pay off, and takes a few years to find her feet in her career in the midst of her world travels. On her thirtieth birthday her dad announces his imminent retirement, and she has an epiphany as she realizes she hasn't thought about her own. Unlike her father's generation, she will not be able to count on a company pension to take care of her – it will be up to her and her savings to make it work.

She comes up with a simple plan, makes a few modest cuts to her spending so she can start to save, and builds an emergency fund in the first year of saving. The next year she starts investing, following the default allocation of having her age less 10 in bonds – now at age 31, she starts with 21% in bonds – and the rest split equally into a Canadian, US, and international fund. She starts by investing $5,000 each year, and increases that 2% each year with inflation.

Though she starts with tempered expectations of how investing will provide returns on a yearly basis, the first few years knock her socks off. Unlike a dull savings account at her bank, her stock portfolio has rocketed higher! At year 5 her modest savings have already turned into nearly $43,000, which only took $26,020 from her pocket!

The good times were not to last, however. Three bad years hit shortly after she started investing: her three equity index funds lost on average 3%, 12%, and 17% those years, but with the bonds to cushion it her overall portfolio was flat the first year, and only down 6% and 11% in the next two years. Her rate of return was less in the recovery that followed because once again bonds lagged stock returns, but because she had less to recover, it would take an all-stock portfolio 11 years to catch up to her more appropriately balanced investments.

Though the stocks out-performed initially and bonds looked like a major drag, deciding to change her plan and reduce her bond holdings because they were underperforming equities after a good 5-year run would have been a mistake for Petra. The bonds played an important role in reducing volatility, which made it much easier for her to stick to her plan through all the ups and downs (well, mostly the downs).

The next decade featured two market crashes, filling the media with stories of fear and a rigged system. The reality, while not quite meeting Petra’s original plan, was not so grim: her portfolio crossed $200,000 as she turned 50. Despite the doom and gloom in the news about a lost decade, she's only about $12,000 behind where she had planned to be at this age – a relatively small amount that doesn't necessarily signal a problem in her plan worth addressing. Nonetheless, Petra thinks that saving too much is a better problem to have than coming up short, so she increases her monthly savings by $100/mo. It's actually an easy adjustment for her, because she had only been increasing her monthly contributions with the inflation rate, while her actual salary had been rising faster than that as she moved up the corporate ladder at work.

Despite the ups and downs of the market over the years, Petra finds that sticking to her plan and tuning out the noise has put her in a fairly decent position for the future, and has the opportunity in the home stretch to make a relatively easy adjustment to stay on course.

Advanced Details on Return-of-Capital: Alex

Alex is pretty financially responsible for a 26-year-old, having made it through school with next to no debt. He's taken his family's advice about living within his means and paying himself first to heart, and as soon as his debts were paid off he set up a non-registered and TFSA savings account and an automatic monthly contribution. He never carries a balance on his credit cards, and he has a dedicated account where he's saving up for his next car so he can minimize any borrowing for that. As soon as January 2^nd, 2014 rolls around he sets up a transfer from his non-registered account to his TFSA version to max out his new $5,500 in TFSA room right at the beginning of the year. From the time TFSAs were introduced to now, he's contributed $31,000, and thanks to the interest he's earned, his account is worth $32,155 after the contribution takes effect in early January.

But he isn't invested in anything more productive than high-interest savings accounts. He got a copy of this book to read over summer vacation in June, 2014. He takes a weekend to review his plan, and realizes that his investments don't match his risk tolerance at all. He opens a Questrade account and prepares to invest in ETFs. He decides that he wants to get started right away, and will use the TFSA shuffle to avoid paying a $150 transfer-out fee from his bank. With the interest earned over the first half of 2014, he has $32,390 to withdraw in June.

At 26, he decides that rounding off to a 20% bond allocation would work for him, and that he will evenly split his equity portion between Canada, the US, and international markets. He doesn't have much RRSP room accumulated yet, and believes that in the next ten years he will be making more at his job and move up into the next tax bracket. So he focuses just on his TFSA for now.

Renting a condo in Vancouver, Alex decides that he will modify the basic asset allocation scheme a bit to include some real estate investment trusts (REITs), tinkering a little bit with core-and-explore. Though he thinks that one day he will decide to own the roof over his head, buying is not something he plans to do in the near-term. After all, he sees all the stories in the news about a potential housing bubble, and even the ones that dismiss the idea start with “except for Vancouver, Canada doesn't have a housing bubble...” Plus he's done the rent-versus-buy math himself to find that renting is the smart choice at those nose-bleed prices. That means all of these savings can be targeted to the long term. He decides to go with the iShares XRE ETF for his REIT exposure, and that it will count as part of his Canadian equity allocation.

With $32,390 in cash now in his non-registered account, his asset allocation plan looks like this:

As he converts from the amount he would like to buy to the number of units, he holds back $10 just in case to cover ECN fees or commissions, in addition to the buffer that comes from rounding down. He enters his limit orders and finds they all fill within minutes.

In January of 2015 he gets his TFSA contribution room back – the $32,390 withdrawn in the previous year – along with an additional $5,500. He calls his account representative at Questrade to make an “in-kind” contribution and puts all of his holdings into the TFSA. Of course, the value has fluctuated over the few months, and the value the contribution is made at depends on the new market value. Alex will have to report any capital gains based on increases in value relative to the contribution because these are “deemed distributions.” Here is how that looks.

Prices as of January 2015 (those used for the in-kind contribution):

XQB, $20.20/unit.

XIC, $23.80/unit.

XRE, $17.33/unit.

VUN, $28.10/unit.

XEF, $26.75/unit.

If XQB, VUN, and XEF are lower than when he purchased them then there will be no capital gains to pay. Because of the superficial loss rule he will not be able to claim the capital loss from an in-kind contribution to his TFSA.

In addition to the change in value, he finds that on his T3 tax slip, XRE paid a return-of-capital distribution (box 42). He subtracts this from his cost base before reporting the gain. Here is his own spreadsheet that he uses for tracking: