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InvestorsFriend Inc. Newsletter May 2, 2010
The State of The Canadian Economy
Investors always worry about the state of the economy.
By most measures the Canadian Economy is doing pretty well.
CIBC World Markets indicates that Canada's GDP grew by over 5% annualized in each of the last two quarters and will grow at 3.1% for 2010.
Statistics Canada's Leading indicators show strong increases:
http://www40.statcan.ca/l01/cst01/cpis03a-eng.htmBut there are some things to worry about.
The recent surge in the Canadian dollar makes Canadian manufacturers less competitive and can easily threaten the existence of many. Consider a manufacturer that was making a 10% profit selling goods to the U.S. when each U.S. dollar was worth $1.10 Canadian. With just a 10 cent rise in the Candia dollar the U.S. dollar is now worth just $1.00 Canadian and a 10% profit margin turns into zero profit.
And consider that a few years ago those America dollars were worth $1.30, even $1.50. There must be hundreds of Canadian manufacturers that primarily sold to the U.S. that are now losing money. And even those that sold only to Canadians now face the threat of much cheaper imports from the U.S. You want Chapters to give you the American price for books and similarly every store and factory wants to get those lower U.S. prices as well. How does a Canadian manufacturer compete with that when its wages and most other costs have not dropped?
Tourism too can be expected to be severely impacted as Americans find that Canada is not the bargain that it was when two of their dollars bought about three Canadian dollars just a few years ago.
The Unemployment rate in Canada is about 8.2% and not expected to decline any time soon. What about all the people whose unemployment insurance and severance benefits are running out and with few new jobs in sight?
Interest rates in Canada are heading up which always tends to cool the economy.
Mortgage delinquencies in Canada are still very low in spite of job losses. Can that last?
The bottom line is that Canada has had a surprisingly strong recovery from the recession, but that recovery may not last. Investors should therefore be cautious.
Your RRSP - It's (Much) Smaller Than You Thought!
"Your" RRSP is not really all yours at all - You should think of it as being about 50% to 75% "Yours" with the other 25% to 50% belonging to the government. The more money you expect to be making when you retire the more of "your" RRSP is not yours at all.
We all know that we have to pay income tax on RRSP withdrawals but the actual way things work can be rather surprising.
Consider a simplified example.
Imagine you contribute to an RRSP and receive a 40% tax break and imagine that your marginal tax rate in retirement will also be the same 40% in this simplified example.
Actually, most Canadians face marginal income tax rates while working and while retired of closer to 30% and some as low as 20%. But the reality is that most people contributing to RRSPs have significantly larger incomes and do face marginal tax rate closer to 40%. In retirement, those with individual incomes over $66,000 face an extra 15% marginal income tax to claw back their old age pension. With this extra 15% their marginal income tax rates are (in Ontario) 48% at $66,000 and rising to 58% at $82,000. The claw back and its extra 15% finally ends at incomes over $107,000.
Despite the old theory that you would be in a lower tax bracket in retirement, the truth is that the people who are most likely to make larger RRSP contributions tend to earn relatively good incomes and could easily be in a higher income tax bracket in retirement thanks to the 15% old age pension claw back.
My simplified example here with a 40% tax deduction when the RRSP contribution is made and a 40% marginal tax rate on withdrawals won't fit every situation, but is a reasonable approximation of reality for many RRSP contributors.
So imagine you make a $10,000 RRSP contribution at age 40. You get 40% back as a tax refund and so your net cost is really only $6000. Now imagine that you withdraw this over several years in your 70's. And imagine that it has grown to $100,000 and you pay 40% or a hefty $40,000 in income taxes on the withdrawal.
The usual way to think about this is that you have paid $40,000 in taxes out of "your" RRSP.
But consider another way to think about this.
Your net cost for the RRSP was only $6000 and it has grown tax-free to $60,000. The government in effect contributed the other $4000 by giving you a tax break.
In effect you always really owned only 60% of the RRSP and the government really owned the other 40%. When the government takes its $40,000 back, all it is doing is taking back its original $4000 plus all those years of growth on the $4000.
You still got 30-plus years of tax-free growth on your net $6000 investment.
The $60,000 that you receive is the exact same amount that you would have if you invested the $6000 in a Tax Free Savings account at the same rate of return.
Here are some of the implications of this:
A $1 in an RRSP is really worth only 50 to at most 80 cents after considering tax must be paid on any withdrawal. In contrast a $1 in a Tax Free Savings Account is worth a full dollar.
When you contribute a $1 to an RRSP however, your net cost is typically only about 60 cents.
So your choice is put 60 cents into an RRSP and the government kicks in another 40 cents and it looks like you have $1.00 but really after considering taxes on withdrawal, you only really have the same 60 cents you put in. Or put 60 cents into a Tax Free Savings account and have 60 cents. It's the same thing as long as we assume the tax rate on withdrawal from the RRSP is the same as it was when you made the contribution.
The RRSP looks larger because the government in effect will lend you 40% of the contribution through a tax break. But the government wants their share and all of the growth on it back when you withdraw the money.
Contributing to an RRSP or Tax Free Savings Account are both smart things to do because they allow for tax-free compounding of investment returns.
With an RRSP the government is effectively a 40% (or so) silent partner in your RRSP. It will take back roughly 40% of whatever the money grows to. And that is fair, it contributed roughly 40% so it wants its fair share back. Meanwhile the tax-system gave you many years of tax-free compounding on your approximate 60% share of the RRSP, so you still benefit greatly.
When doing a net worth statement you should realize that "your" RRSP is not really 100% yours, it's more like only 60% yours and you should only count 60% of it when doing a net worth calculation. (Although possibly as high as 80% of it is yours if you can somehow get into a lower tax bracket in retirement, and possibly as little as 42% of it is really yours if you are in Ontario and will make between $82, 000 and $107,000 in retirement and will therefore be paying old age pension claw back of an extra 15 cents on every RRSP dollar withdrawn).
So... in summary... A dollar in the hand is worth (about) two dollars in the RRSP bush.
Understanding The Canadian Economy
We have updated out article on Understanding the Canadian Economy. Key conclusions are that manufacturing remains a very large component of the economy and that the United States remains far and away our major trading partner. The contribution of energy and other natural resources to the Canadian economy appears to be wildly exaggerated in the popular press compared to what this data shows.
In Praise of Big Retail
It's a shame that big retailers like Wal-Mart and Home Depot come in and push out independent stores.
But the fact is that big retail is simply a more efficient method of getting products from manufacturers to the consumer.
It's often said that the big chains undercut the small independent retailer because they have buying power. According to this theory, the big stores can buy their products cheaper. That is no-doubt partly true, but it is not at all the full story.
Big retailers also charge a much smaller markup. Wal-Mart for example marks its products up by an average of only 33%.
Target marks up by an average 45%, Costco with its wholesale approach and limited selection marks up by an average of only 15%.
I don't have the figures for what an independent store would mark things up. I do see that Reitman's in its Q3 report mentioned a gross margin of 64%. That means, on average, they buy an item for 36 cents and sell it for $1.00, a mark up of 178%.
Yet Reitman's is not more profitable than the huge retailers I mentioned. My conclusion is that smaller retail must simply face far higher administrative and building-related costs as a percent of their revenues.
Big Retail is extremely efficient and can afford to mark things up by 15% to 45% and still make large profits. Meanwhile a small retailer probably needs mark things up by at least 100% just to survive.
My conclusion is that Big Retail is simply a far more efficient way to get products to the store shelves.
There are many other factors to consider such as better service at small stores. It's no real savings if your shoes were half the price at Wal-mart but they actually don't fit your feet.
But for commodity type products where you don't need any special help to make your purpose, it is very difficult to argue against shopping at big retailers who can save you a lot of money due to their efficiency.
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END
Shawn Allen, Chartered Financial Analyst
President
InvestorsFriend Inc.
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