When Tax-Free Savings Accounts (TFSAs) were introduced in 2009, they were billed as the best thing to happen to Canadian investors since the RRSP, which was first introduced in 1957. That’s rather heady hype in and of itself, but in the end that statement was warranted. In my opinion, used properly, TFSAs are an excellent investment container for holding a portion of your investment portfolio, and every Canadian should consider using one as part of their overall investment strategy. But what to put into it? That’s where things get a little prickly.
You might forgive a cynic (translation: experienced market observer) like me for not immediately jumping on the TFSA bandwagon. The plain truth is that I was overwhelmed by the intense marketing campaigns launched by the banks, brokerage firms, and mutual fund distributors in late 2008 and early 2009, each of them extolling the virtues of this new account type. And extolling is an understatement.
It was not uncommon, for example, for a financial institution to present an ad showing how $5,000 could be spun into $50,000 in a few months if you used a TFSA “correctly.” It was as if, all of a sudden, the probabilities of executing a 10-bagger in a few months had suddenly improved, just because some politicians had signed legislation that this 10-bagger would now be tax-free. Almost as if it wasn’t really worth the effort to turn $5,000 into $50,000 before the TFSA existed, but now it was. Such was the character of the ad campaigns when TFSAs first came out.
The big commission hunt
Of course, these financial institutions were not guiding prospective clients towards greater wealth and a better retirement with these TFSA ads. They saw the TFSA as a conduit to get themselves more fees and commissions. The TFSA really was a gift from the federal government to its beleaguered taxpayers. But what the banks and other financial institutions saw instead was an opportunity to transfer that taxpayer benefit, and more, to themselves.
That’s the background to why I say that the TFSA is a “good container,” but it should be used properly. The financial institutions are uniform in their opinion that using a TFSA “correctly” involves filling it up with mutual funds, stocks, bonds, ETFs, and anything else they sell that has a fee or a commission attached. In my opinion, this approach simply causes the tax benefit of no tax on the bitty amount of income you get from a TFSA to be dwarfed by the fees that it costs you to get that income. In my opinion, the investment products listed above do not belong in a TFSA.
In my opinion investors should hold only cash in a TFSA.
Here’s why. First and foremost, I believe that investors should take a portfolio approach, which means that the most important focus is on their allocation among cash, fixed income, and equities. Now, on which of those three asset classes is it most difficult to earn a superior return?
Think about it. With equities you can rotate from one sector to another, one industry to another, and even one geographic region to another to better your return. You can tilt towards growth securities or value stocks or go with momentum. You can go with dividend payers, small caps, micro caps, mid caps. There are myriad ways of seeking a better return with equities.
So too with fixed income. You can alter your average coupon, and adjust your average term to maturity. You can choose between corporate or government bonds, mortgage bonds, strips. There are high-yield bonds, preferred shares, distressed bonds, bonds from emerging countries. There are myriad alternatives to get a better return.
The return on cash
Not so with cash. Cash is an important component to any balanced portfolio, and everyone needs to hold some minimum of cash at all times. But how do you earn a superior return on cash? The simple answer is that you can’t.
Right now the best you can do with your cash allocation is 2.43% on a ($50,000 minimum) five-year GIC. Given that annual inflation today runs about 1.5% (2012 The Economist Dec. 22 forecast for 2012), that doesn’t leave a lot in terms of real return. And if that 2.43% attracts any kind of tax, the investor will be looking at a negative return.
That’s my point. As simple as it is, I hope you see it as also being true. You must have some cash in your portfolio. That cash already has a hard time beating inflation. You can’t pay tax on that income, or you’ll have a negative return. So why would you pay a fee to a financial institution, for something like a money market mutual fund, just to make that negative return more negative?
Incidentally, one of the few drawbacks I cited for the new TFSA back in 2009 was the low contribution limit of $5,000. In 2009 you could make maybe $200 in interest on $5,000 in a year, which means a tax benefit (for a person in a 50% marginal tax bracket) of a mere $100. If it costs you $100 in fees and commissions to make that $100, then what’s the point?
That low limit, though, is not now an issue. As of 2013, the TFSA contribution limit rises to $5,500, for a total $25,500 “contribution room” since inception. (In other words, if you haven’t ever opened a TFSA, you can now do so and immediately pop up to $25,500 into it.) The low initial limit is now not just a low total limit. TFSAs are now a legitimate container to hold the cash portion of portfolios of most any retail size.
Bottom line: Use a TFSA, and use it for cash first. Cash is defined here as savings accounts, GICs, term deposits, and money market instruments such as CDs and T-bills, but specifically excludes money market mutual funds.
David West, CFA, FCSI, has more than 30 years’ experience in the financial services industry as an adviser, trainer, writer and commentator. He has written for The MoneyLetter and Canadian Business Online among others, and is a regular contributor to the Fund Library.
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