Taxes & Wealth Management: Path Dependency in Financial Planning, Retirement Edition

8/11/2019 Taxes & Wealth Management: Path Dependency in Financial Planning, Retirement Edition

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PRESERVING WEALTH FOR PEOPLE AND PRIVATE COMPANIES

TAXES & WEALTHMANAGEMENT

IN THIS ISSUE

Editors: Martin Rochwerg, Miller Thomson LLP;

David W. Chodikoff, Miller Thomson LLP;

Hellen Kerr, Thomson Reuters

Revisiting Sommerer v. The Queen The Canadian Common Law and TaxTreatment of an Austrian Private Foundation ..... 1

Allison's Brain .....................................................4

Path Dependency in FinancialPlanning: Retirement Edition ..............................5

Tax Inversions: A Legitimate Means ofTax Avoidance But, for How Long? ..................

Proposed Changes to Charitable Giftsby Will ................................................................1

The Thin Capitalization and ProposedBack-to-Back Loan Rules .................................. 12

Joint Tenancy Has Its Own Pitfalls .....................17

Aboriginal Rights A Hidden Cost ofInvesting in Resource Development inCanada .............................................................. 18

Investing in Permanent Life Insurance .............. 19

Residency Tiebreaker Rules in Canadas

Income Tax Treaties: All is Not as it Seems ....... 21Mitigating U.S. Tax exposure throughthe Closer Connection Statement .....................23

Cases of Note ....................................................23

SEPTEMBER 2014 | ISSUE 7-4

PATH DEPENDENCY INFINANCIAL PLANNING:RETIREMENT EDITION1 By Adam Butler, Mike Philbrick and Rodrigo Gordillo, PortfolioManagers with Butler|Philbrick|Gordillo & Associates atDundee Goodman Private Wealth

And now the sequence of events in no particular orderDanRather

Imagine for a moment sitting at the kitchen table, steamingcoffee in hand. The sun is streaming in the windows, bacon ispopping in the pan, and Rover drops the paper at your feet. Abrilliant Saturday morning by any measure, but today is extraspecial. Now youre retired!

When you open the paper to the front page you notice thatsomething is strange. First, the pictures are moving as thoughthere is a movie embedded in the page instead of a picture. Thetext is in a strange font, and is so clear that it almost jumpsfrom page to eye. When you start to scan the rst article, youare startled to discover that a womans voice seems to bereading the words directly into your mind.

Your eyes dart to the top of the page, searching for thepublishing date of the paper: August 1, 2045. Your gut falls,pulse is pounding; deep breath, calm yourself. A few minuteslater, coffee and bacon forgotten, you are ipping urgentlythrough the paper maybe it will disappear just as quickly as

it appeared!Strange names, strange places, strange devices; what wonders!

Then you are in the business section. Numbers scroll across thetop of the paper: every major market is listed and some newones, along with their current prices. A bell goes off in yourhead, and a smile paints its way across your face.

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TAXES & WEALTH MANAGEMENT SEPTEMBER 2014

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You work the math. Youre 63 years old today. Your retirementplan was engineered to last you and your spouse 32 years untilyou turn 95 in the year 2045. How fortuitous!

You scan the business pages, but cant nd any individual stocklistings, just closing values for major markets and asset classes.Quickly, you compare the prices listed for indexes in the paperto the most recent closing prices until you nd the market withthe best returns over the next 32 years.

You discover that the best market will deliver returns of 8%per year. Retirement Nirvana is just a few clicks away with your

trusty Excel spreadsheet. No more anxiety, no more sleeplessnights. Youre set.

Or are you?

BOOKENDS

While you now have information about average returns for thebest market over the next 32 years, you have no idea what paththat market will take to get there. In your minds eye, it lookslike the trajectory in Chart 1; a beautiful arcing growth curvefrom point A today to point B 32 years from now.

Chart 1. The retirement curve in your minds eye 2

But in reality, the paths that the index might take to achievethat level are limitless. For example, the index might surge inthe rst few years and then move sideways for the last couple ofdecades, like the red line in Chart 2. Or it might move sidewaysfor the rst three decades, and deliver all the returns in thenal two years, like the green line.

Chart 2. Two alternate futures 3

I know what youre thinking: Why does it matter in whsequence the returns are generated if we know exactly wherethe index will end up? Why do I care if returns come early late, or are spread evenly through time?

These are great questions. Indeed, if we were to invest a lumsum in the index today and leave it there for 32 years it woul

2 http://gestaltu.com/wp-content/uploads/2013/08/minds_eye.png . 3 http://gestaltu.com/wp-content/uploads/2013/08/red_green.png.

not matter at least mathematically which path the indetravelled to get from A to B.

Unfortunately, most retirees arent in that situation. Rather,most people expect to draw a steady income from theiportfolio, withdrawing monthly, quarterly or annually aamount that keeps them in a certain lifestyle, adjusted eachyear for ination. As we will see, this subtle change in objectican have a profound impact on nancial outcomes.
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NICK AND NANCY: A CASE STUDY

Lets zoom in for a moment on Nick and Nancy, both 63.They are about to embark on the great retirement adventure.Through sacrice, wisdom, perseverance and some luck4 the couple has accumulated $3,000,000 in savings over Nicksalmost four decades as a corporate lawyer. Nancy is pretty goodwith a spreadsheet so, with the help of their accountant, shecreated one to determine how much pre-tax income they candraw each year from their combined nest egg. Their analysisyielded the results depicted in Chart 3.

The red bars in Chart 3 represent the income that Nick andNancy expect to draw each year from their portfolio, adjustedfor ination. You can see that in the year after retirementthey expect to draw about $180,000, and this amount scalesby 3% per year, to account for expected ination. The blueline describes the evolution of Nick and Nancys wealth afteraccounting for investment growth at 8%, and their annualwithdrawals. Note that their total wealth seems to peak ataround age 75 near $3.5 million before tapering off aggressivelytoward their estimated age of mortality: 95.

Chart 3. Example retirement schedule from age 63 through 955

To summarize:

Nicks current age: 63

4 http://gestaltu.com/2013/09/planning-adverse-scenarios.html .5 http://gestaltu.com/wp-content/uploads/2013/11/Traditional_Plan.png .

Retirement savings: $3 million

Modeled sustainable income: $180,000

So, from our future newspaper Nick and Nancy know that theyare going to invest in a portfolio that delivers 8% per year, onaverage, over their 32-year retirement horizon. What they dontknow is the sequence in which those returns will materialize.In the next section we will demonstrate how this seeminglybenign missing piece to the puzzle will decide Nick and Nancysretirement fate.

LUCKY NOW, OR LUCKY LATER

For the sake of illustration, lets assume that the best indexover Nick and Nancys investment horizon is the Dow JonesIndustrial Average. Nick and Nancy condently withdraw anincome each month to fulll their lifestyle expectations, and allof their money is invested in this index.

Lets also assume that the Dow delivers exactly the samereturns over the next 32 years that it delivered over the years

1966 through 1997. This period was chosen because the returnsto the Dow over the period were exactly 8% (or near enoughfor government work), and because it captured a long sidewaysmarket in the 1970s as well as a long powerful bull marketfrom 1981 through the late 1990s. Chart 4. plots the priceperformance of the Dow over this period.

Chart 4. Dow Jones Industrial Average Index (1966 1997)6

Data source: Bloomberg

Again, note that the average return to the Dow over this periodis 8% per year. However, if you look closely you will see thatthe returns are not evenly spaced over time. Rather, from 1966

through 1982 there are essentially no returns, as the indexbegan the period at 1000 and ended the period at the samelevel. Then, from 1982 through 1997 the Dow grew at over 15%per year taking the index from 1000 to about 8000. Charts 5

6 http://gestaltu.com/wp-content/uploads/2013/08/dow_full_period.png .
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and 6 zoom in to provide a better perspective on these two verydifferent market regimes.





PATH DEPENDENCY

In our rst instance, lets take the straightforward examplewhere Nick and Nancy experience exactly the same returns, inexactly the same order, as the Dow index delivered over the 32years from 1966 to 1997. Remember, in the early years Nancyand Nicks portfolio is large relative to the amount of their

annual withdrawals, while in the back half of their retirementhorizon, after theyve spent many years drawing down income,the portfolio is relative small. Obviously, the portfolio is morevulnerable to poor returns when the portfolio is large than it iswhen the portfolio is small.

7 http://gestaltu.com/wp-content/uploads/2013/08/Dow_66-81.png .8 http://gestaltu.com/wp-content/uploads/2013/08/down_82-97.png .

In this example where the markets play out as they actually dihistorically, market growth would materialize in a manner thasomewhat resembles the green line in Chart 2 above: sidewayearly on with a late surge. Chart 7 shows the trajectory of theiretirement wealth given this market return trajectory, including

withdrawals and growth.Chart 7. Retirement wealth trajectory: weak early returns andstrong late returns 9


Remember, Nick and Nancy knew for certain that they woulachieve 8% average compounded returns over the full durationof their retirement horizon. However, in this rst examplewhere the poor returns come early in the retirement horizonthe couple is completely broke over 15 years before theexpected age of mortality. That is, Nick and Nancy must endur

their remaining 5, 10 or 15 years in retirement on CPP (socisecurity) and old age social subsidies alone. A pretty diroutcome.

For our second example, we will mix things up. Rather thaexperiencing the long, volatile sideways market from 1966 t1981 rst, followed by the strongly surging market from 19to 1997 later, we will reverse the order. In this case, imagina situation where Nick and Nancy experience the long bumarket from 1982 to 1997 in the early part of their retiremenperiod when their nest egg is very large, and then experiencthe 16 years of poor sideways markets in the latter half. Char8 shows Nicks and Nancys retirement trajectory under thes

new assumptions.

9 http://gestaltu.com/wp-content/uploads/2013/11/Returns_late.png .
http://gestaltu.com/wp-content/uploads/2013/08/Dow_66-81.pnghttp://gestaltu.com/wp-content/uploads/2013/08/down_82-97.pnghttp://gestaltu.com/wp-content/uploads/2013/11/Returns_late.pnghttp://gestaltu.com/wp-content/uploads/2013/11/Returns_late.pnghttp://gestaltu.com/wp-content/uploads/2013/08/down_82-97.pnghttp://gestaltu.com/wp-content/uploads/2013/08/Dow_66-81.png


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Chart 8. Retirement wealth trajectory: weak early returns andstrong late returns 10


Note how this chart looks much more like Chart 3, which was

the retirement model that Nancy created when she analyzedtheir prospective retirement trajectory. In this example, Nickand Nancy are able to withdraw their desired income each year,adjusted for ination, and still end up with over $4 million interminal wealth. Now we see why Albert Einstein allegedlyclaimed that compound growth is the most powerful force inthe universe.

INDIVIDUAL RATE OF RETURN

It is critical to remember that the Dow Jones Industrial Averagedelivered average returns of 8% per year in both examplesabove. With no cash ows going in or out of the portfolio,

the order of returns is completely inconsequential. It doesntmatter whether returns come early or late; the Dow still ends inexactly the same spot.

However, when we introduce cash ows into the equation,things change dramatically. We saw that, with exactly the samewithdrawals, and exactly the same long-term average marketreturns, Nick and Nancy ended up in two dramatically differentsituations. On one hand they died with over $4 million in wealthfor heirs, charity or other valued causes. On the other hand theywere at broke at age 79, fully 16 years earlier than expected.So what matters most to Nick and Nancy, the average returnfrom the market, or the average growth of their portfolio?

The average rate of return on a series of cash ows is referredto as the Internal Rate of Return. It is also referred to as thedollar weighted rate of return. We refer to the average dollarweighted rate of return that a person receives on his personalportfolio as his Individual Rate of Return, and it is theonly rateof return that should matter to investors who are either savingmoney, or withdrawing money from their portfolio over time.

10 http://gestaltu.com/wp-content/uploads/2013/11/Returns_early.png .

Table 1. compares the average rate of return on the DowJones to the Individual Rates of Return that Nick and Nancyexperienced in their portfolios in the two examples above. Notethat the IRR from the model is less than 8% due to the waydollar weighted returns are calculated over time in contrast to

the 8% arithmetic return of the index.Table 1. Comparing Individual Rates of Return (IRR%)

IRR %

Model 7.37%

Good returns come early 8.36%

Good returns come late -2.41%

Chart 9. Early returns versus late returns11

Table 1 clearly shows that an investor with the exact samesavings and the exact same average market return canexperience a +10% difference to actual realized portfoliogrowth, or Individual Rate of Return, simply due to luck. Aninvestor who is lucky enough to experience strong marketgrowth in the front half of their retirement horizon mayexperience double, triple, or better growth than an investorwho is unlucky enough to have most of his strong returns comein his later retirement years. In the case of Nick and Nancy, aweak sequence of returns resulted in total depletion of theirwealth after 16 years of retirement, while a strong sequenceresulted in a $4 million legacy.

DO YOU FEEL LUCKY, SIR?

Nick and Nancy discovered that it is not enough to knowthe long-term average returns that they can expect fromtheir investment portfolio. It is also important to accountfor potentially adverse sequences of returns. For savers, it isproblematic to invest in a portfolio with the potential to deliverhigh returns in early periods followed by low returns in laterperiods. For retirees (and endowments and pensions) in a netwithdrawal situation, sequence of returns is equally important.

11 http://gestaltu.com/wp-content/uploads/2013/11/comparison_chart.png .
http://gestaltu.com/wp-content/uploads/2013/11/Returns_early.pnghttp://gestaltu.com/wp-content/uploads/2013/11/comparison_chart.pnghttp://gestaltu.com/wp-content/uploads/2013/11/comparison_chart.pnghttp://gestaltu.com/wp-content/uploads/2013/11/Returns_early.png


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of sideways to set up for a long growth market a decade in oufuture?

Adam Butler, Mike Philbrick and Rodrigo Gordillo are PortfoManagers with Butler|Philbrick|Gordillo & Associates Dundee Goodman Private Wealth in Toronto, Canada.

Adam, Mike and Rodrigo can be found atwww.bpgassociates.com.

However, the situation is reversed, such that investors inwithdrawal will be adversely affected if returns cluster later inthe investment period, with lower near-term returns.

For investors in traditional portfolios this sensitivity to thesequence of returns can be seriously problematic. Thatsbecause both stocks and bonds are prone to periods of low,volatile returns that last many years or even decades.

The following chart shows the long-term returns to the DowJones Industrial Average back to 1998. Note that periods ofstrong returns coloured green in the chart have lastedbetween 5 and 17 years, and delivered cumulative returnsranging from 150% to 1000%. These green periods of long-termgrowth are invariably followed by red periods of low or negativereturns that have lasted from 17 to 25 years historically, anddelivered cumulative returns between -4% and 12% over theirentire duration.

Chart 10. Long term Dow with secular bull and bear markets12

Source: Guggenheim Investments

Note that we are currently about 13 years into the most recentred sideways period. The question is, are we near the middle ofthe sideways period, or did we turn the corner in 2008, settingup for a new long-term growth cycle? (See our articleValuationBased Equity Market Forecast December 2013 Update atwww.gestaltu.com for answer to these questions).

The answer has profound implications for investors. Are wesetting up for a decade of strong returns right now, whichwould prove to be a boon for recent retirees but unfortunatefor young savers? Or will we experience another 5 or 10 years

12 http://gestaltu.com/wp-content/uploads/2013/08/sec_bull_bear.png .
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Taxes & Wealth Management: Path Dependency in Financial Planning, Retirement Edition