In a recent interview, MoneySense Editor Jon Chevreau asked Mercer actuary Malcolm Hamilton whether he still thinks that saving in taxable accounts is futile and Mr. Hamilton had this to say:
It’s always better to invest inside tax shelters than outside. Some Canadians have to invest outside tax shelters because they exhaust their tax shelters and they still want to save more. So they have to save outside. The problem is if you are earning, you know, let’s say, 3 or 4 percent interest and it’s 50 percent taxable, then it means after tax it’s 1-1/2 to 2 percent and, uh, in a 2 percent inflation world that means all you are doing in terms of purchasing power is marking time. So, when I say it’s futile you are not really going to make any money in real terms, after fees and taxes and inflation, you’ll be lucky to break even and in all likelihood for the forseeable future given how low interest rates are and how much that’s being done to get inflation a little higher, you may well gradually lose money. So, in that sense it is futile. It’s not a wealth generating activity. Now, if you have to invest outside tax shelters, it’s still maybe the best you can do. Like, maybe the best you can hope for is sort of a gradual, controlled loss of purchasing power. It’s sort of a depressing prospect but if that’s the only game in town, then that’s still the game you got to play. So, my advice to people is, by all means, if you can put your money in tax shelters do so. If you have to have some money outside tax shelters, again that’s probably where you want your equities. Your fixed income you can ill-afford to have outside tax shelters because they are taxed so heavily. So, to the extent that you got money inside, money outside try to get your heavily taxed stuff in the tax shelters and your more lightly taxed stuff like equities outside and just hope for the best.
As Mr. Hamilton is one of the sharpest guys around, it was surprising to hear him say that investing in taxable accounts is “not a wealth generating activity”. Mr. Hamilton is surely correct about investing in fixed income in taxable accounts and the superiority of tax-sheltered accounts such as RRSPs and TFSAs for holding investments. However, one would suspect that investing sensibly in taxable accounts is likely to produce satisfactory results. So, I constructed a model to compute the impact of distributions, inflation and taxes on investments made in taxable accounts. You can find it here. The model assumes an investment of $10,000 made over 25 years. The parameters are: expected total returns, returns in the form of distributions, inflation assumptions, turnover and tax rates on distributions and capital gains.
Let’s first test Mr. Hamilton’s contention that if one is invested in bonds or GICs in a taxable account, one is experiencing a gradual loss of capital in real terms. We’ll assume total returns of 2 percent, interest income of 2 percent, inflation of 2 percent and a tax rate on distributions of 45 percent. We find that investors are indeed losing capital at the rate of 0.90 percent every year. In 25 years, the initial capital of $10,000 has dwindled to $8,000 even though in nominal terms, the investment has grown to $13,000. Conclusion: Unless there is a very good reason such as a downpayment on a soon-to-be-purchased home or the college funds for a kid heading to University in the next couple of years, it is indeed a bad idea to invest long-term funds in fixed income in taxable accounts.
It is interesting to observe that even a 0 percent real return in fixed income in a low interest rate environment is better than a 2 percent real return in fixed income in a high inflation environment. Assume bond interest rate of 10 percent and inflation of 8 percent and we find that the real after-tax rate of return is negative 2.3 percent over a 25 year period. That is enough to turn $10,000 into $5,500 in real terms — a truly staggering loss of purchasing power. Conclusion: In high-inflation environment, you really should avoid investing in fixed income in taxable accounts.
But what about investing in equities? Is it worthwhile to do so in taxable accounts? Let’s make some conservative assumptions. Total return is 6 percent, 3 percent of which is supplied by dividends. Inflation is 2 percent and the portfolio is turned over 5 percent every year. The tax rate on dividends is 25 percent and on capital gains is 22 percent. Roughly, this model will capture the experience of an Ontario investor in the top tax bracket who has invested in a broad market Canadian index fund. In this scenario, we find that wealth does grow, albeit slowly in real terms. After 25 years, the initial investment has almost doubled in real terms and the real, after-tax rate of return is 2.8 percent. Conclusion: If all tax sheltered vehicles are exhausted, investing in equities while keeping costs and turnover low in taxable accounts will increase wealth, albeit at a modest pace in inflation-adjusted terms.
But what about investors who invest in typical mutual funds that charge a fee of 2.5 percent. The expected total returns drops to 4 percent compared to 6 percent for an indexed investor. Assuming distributions of 0.5 percent, one finds that the after-tax return drops to 1.3 percent, which will turn the initial investment of $10,000 into $13,700 over 25 years — that’s less than 40 percent of the growth experienced by the low-cost, low-turnover investor in the previous scenario. At least, the returns are not as awful as that of the fixed-income investor.
The model shows how powerful deferring taxes in investment accounts is. If an investor is comfortable with the Horizons S&P/TSX 60 Index ETF (TSX: HXT), which employs swaps to capture the TSX 60 total return and the total return is 6 percent and inflation is 2 percent, an investor ends up with an after-tax inflation adjusted rate of return of 3.2 percent over 25 years. That will turn an initial investment of $10,000 into $21,700 or roughly 20 percent more than an investor who incurs an annual tax hit on dividends and distributed capital gains. Conclusion: The total return swap structure employed by HXT, which avoids turnover and distributions, provides a strong advantage for taxable investors.
