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Why Mutual Funds?

Canada, like most other industrialized countries, faces the challenge of a rapidly growing population of retirees who will need sufficient income to see them through retirement. With people living longer, Statistics Canada projects that by 2041 the number of people aged 65 and over will more than double to approximately 10 million people.

Canadians will receive their retirement income from government plans, (CPP, OAS, and GIS), private pension plans, RRSP's and their non-registered investments. For many years we heard that the Canada Pension Plan was under funded and that the baby boomers should not expect to receive CPP. For the last ten years we have seen our CPP contribution rates rise and the CPP is now managed by investment professionals from the private sector who have the authority to invest in stocks, bonds and real estate around the world. There is now confidence that CPP is in a sound actuarial position and that the baby boomers should be able to collect the CPP benefits promised to them. As an aside, Social Security in the United States has not been fixed and is not actuarially sound. It is a huge problem that the American people are going to have to deal with at some point. Canadians can be thankful that positive changes have been made to CPP over the last ten years.

Retired Canadians who earn a higher income see their Old Age Security clawed back once they hit a certain income threshold, and that trend will continue. We will probably see the income threshold lowered and increasing numbers of retirees will see their OAS clawed back as more Canadians retire. It is probably not wise to consider Old Age Security (OAS) in your retirement projections.

The prevalence of private pension plans is declining. The number of self employed Canadians is rising and many smaller companies do not offer pension plans. Employees in the past who worked for large corporations could count on a defined benefit pension plan that would deliver them an income that could be estimated well in advance of retirement, and provide a guaranteed income while retired. Many employers, including larger companies, are switching their pension plans to defined contribution from defined benefit plans. The difference is that the employees share in the investment risk of defined contribution plans. The more the plan earns, the larger the retirement income. The reverse is also true. If the defined contribution plan does not do well with its investments, the members of the plan will suffer.

Many employers also offer a group RRSP in lieu of a pension plan. Often a group RRSP is based on matching contributions from the employees up to a stated limit by the employer. In other words, if an employee contributes their savings to a group RRSP, the employer will match the employee's contributions up to an agreed limit. Group RRSP's can be offered as an enhancement to an employer sponsored pension plan, or in lieu of the pension plan.

RRSP's are a very popular way to save for retirement. For the majority of Canadians there is no better way to save than through mutual funds. There is no other investment vehicle that gives the average investor a greater opportunity for growth than mutual funds. Mutual funds give every investor, whether large or small, professional management, diversification of investments, and clear reporting.

The goal for investing is to earn a rate of return higher than inflation, minimize risk, minimize taxes, and maximize returns. This is the difficult part of investing. There are thousands of mutual funds in Canada and many of them do not meet the needs of investors. The goal is to pick the right mix of mutual funds that will provide the optimum after tax income required for an investor's retirement.

Mutual funds have been criticized for having fees that are higher than can be justified; poor long term returns; and for being too volatile. All of these criticisms are valid for numerous funds that are on the market. Many investors buy the wrong funds at the wrong time, for the wrong reasons.

An example is that many investors bought technology funds, or diversified funds that were over-weighted in technology in 1999 and 2000. Many investors were selling off their energy funds at the same time. The five year rates of return were outstanding on any fund holding technology, and very poor for energy funds. What happened? Energy funds have enjoyed a spectacular five year rate of return from 2001 to 2006. Technology funds have been a disaster for the same five year period.

The way to get around "market timing" mutual funds is to avoid specialty funds and only invest in well diversified funds with good long term records. Results can and will often be poor in the short term for all funds, but generally in the long term quality funds do well. (Diversified means having a mix of bonds, income trusts, and stocks from markets around the world in a portfolio.) The challenge is to get the right mix depending on a client's age, risk tolerance, and time horizon. The even bigger challenge is defining the word "quality". In the investment world,"quality"is very subjective as each investor has a different tolerance for market volatility, and each investment advisor has their own unique approach when advising clients. Investing can never be considered an exact science.

The question asked is "Why mutual funds?" There is no other investment vehicle that can provide the same professional management to the small investor that larger investors enjoy.

What about segregated funds? They are also excellent investment vehicles. Segregated funds are mutual funds with an insurance wrapper around them. The principal invested into segregated funds is managed the same as mutual funds, but on some segregated funds you can have up to 100% guaranteed on death and a future maturity date. This means that if a client invests funds into a segregated fund, the amount invested is guaranteed to be returned to their beneficiaries on the event of death, or to themselves after a ten year period. Many segregated funds have the option of locking in the returns on a fund by re-starting the ten year guaranteed period. For example, if an investor invests $5,000 into a segregated fund, the $5,000 is guaranteed to be returned to the investor on death, or in ten years. If the fund grows to $7,500 at some point, a new guaranteed period can be started for the increased amount. Most segregated funds allow an investor to lock in their gains up to twice a year.

Segregated funds are also creditor proof in most circumstances which is another benefit for self employed people. The guaranteed death benefit is a very large advantage for older investors, as market fluctuations will not affect the principal on death, and the value of the plan on death is paid to the named beneficiaries without any probate fees. The drawback of segregated funds is that management fees are higher than regular mutual funds to cover the guarantees, and this will have an effect on the long term investor's rate of return. The main advantage of segregated funds is that they give investors who are overly concerned about equity markets a sense of comfort.

What about management fees on mutual funds? Many investors who have a life partner end up with regular RRSP's, locked-in retirement accounts (LIRA's), spousal RRSP's, and then their partner also have their own RRSP's and locked-in retirement accounts. An investor's family may have significant investable assets, but they are broken up into numerous different accounts that cannot be combined for investment purposes. Today workers are very mobile, and they accumulate funds in different pension plans that they can then transfer to locked-in retirement accounts when they leave their employers. Mutual funds are an excellent vehicle to deliver professional management to all the different types of retirement accounts that clients accumulate in their lifetime.

Today many larger clients "graduate" to private money management accounts that do provide lower management fees than mutual funds. Also, there are investment vehicles inside the mutual fund world that allow the management fees on non-registered accounts to be tax deductible. This is a huge advantage to investors as it improves the after tax return. Unfortunately fees on registered accounts are not tax deductible. It is only natural that investors with larger account size will benefit from lower management fees in the private money management world. The argument is that mutual fund investors get the exact same professional management in their mutual funds as the most sophisticated investor gets in the private money management world. Though management fees in the mutual fund world may seem high to some, they are actually quite reasonable if the manager provides good returns, minimizes taxes and the fund company offers excellent reporting to the client.

Today's investors have an advantage over those from five years ago. It is now an easier time to choose managers with good long term returns. The period from 2000-2002 was one of the toughest periods in the investment world in the past thirty years. The period from 1995 to the beginning of 2000 was one of the best periods in the market in the past twenty years. Most investment professionals were not working in the industry during the last very difficult period which was the 1972-1973 period. There are a number of companies who do independent analysis of every mutual fund in Canada. One of my favorites is Globe Advisor through the Globe and Mail. You can look up a fund's performance from 1995 to 2005 to see how consistent the annual returns were. If there was large volatility, it may not be the fund for you. If the manager made money in the 1995-2000 period, and continued to eke out a small gain in 2000, 2001, and 2002, or only suffered a small loss in the difficult period, this is a manager who knows how to manage risk. It is important when you look at the fund to see if the manager now named on the fund is the one who managed the fund from 2000-2002. If this is not the case, you will want to find out the manager's performance on previous funds they managed during the difficult period, before deciding to invest your money.

Many mutual funds have one additional advantage that almost no other investment vehicle enjoys. Many of the larger mutual fund companies offer"Capital class"funds. This means that all dividends in any non-registered investment can be sheltered from tax until the fund is sold. Dividends are a critical part of the total rate of return, and if dividends can be sheltered from tax on an annual basis, the compounded rate of return is enhanced. It is not only what you earn on a fund, what is left over after tax is even more important. (Dividends inside registered accounts are compounded tax free.) Mutual funds are the only investment vehicle that can offer tax deferred compounding on non-registered investments through capital class funds.

The goal of a professional advisor is to choose managers that have a "repeatable process". This means that a funds' excellent short-term performance was not due to luck, but to skill. The manager should have a process for analyzing stocks that will continue to deliver good returns on a regular basis. The 2000-2002 period separated those managers who were"riding the technology wave"from those who knew how to manage risk, and shift investments from one area to another to deliver good consistent returns. Though the good managers are a minority, there are many of them out there for your professional advisor to choose from.

It is said that "stock markets reflect human nature". "We act much more outrageously in a group or crowd than we do on our own." The key to success in the markets is to"take the emotion out of the market"."Clients want to do well in the upside, and don't want to be burned in the downside." "Dividends are a critical part of total return."Stock markets are a leading indicator of millions of small investors forecasting the future".
…Kim Shannon, a leading Canadian portfolio manager.

There are many professional investment managers in Canada and around the world who can provide you with professional management to help you reach your retirement goal. It is not easy to find them as they tend to move around and companies merge, get sold, or buy competitors. Getting the right mix of investments from the right managers is the key to your financial success. Your financial planner can help you put together the right mix of mutual funds to meet your goals.

This is not an official publication of Independent Planning Group Inc and the views expressed in this article are not necessarily those of Independent Planning Group Inc. This article is intended as an information service with the understanding that it does not render any legal, market predictions, tax or other professional advice. It is recommended that readers consult their professional advisors regarding any matter addressed in this article. The information and opinions contained in this article are obtained from various sources and believed to be reliable, but their accuracy cannot be guaranteed. Readers are urged to obtain professional advice before acting on the basis of material contained in the article. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

Richard H. Kizell, B.A., RFP, CLU, CFP, is Manager of an Independent Planning Group Financial Planning Centre in Kingston. Affiliated with Independent Planning Group Inc. and IPG Insurance Inc.