How to prepare your portfolio for what happens after the pandemic
For most Canadians, the COVID-19 pandemic started hitting home a little over a year ago, in March of 2020. But it seems like forever since we’ve been mask-wearing, social distancing and “stay-at-home”-ing.
The cost, both in money and in human lives, has been enormous. But there is good news on the horizon. The restrictions and challenges brought on by the pandemic will eventually ease. Life will eventually return to some level of normalcy: we might be able to go out to a restaurant, for example. Or go on holiday overseas. Or go over to our friend’s place for a cup of coffee. Or simply be able to go for a walk without wearing a mask.
If you’re like most snowbirds, your portfolio has probably suffered through the pandemic. But there’s good news here, too: the unemployment, stock market volatility and general economic mayhem will eventually come to an end as well. The economy will return to some level of normalcy − the stock market largely has already.
But there are new risks and challenges on the horizon. Now, as we prepare for the end of the pandemic, it makes sense to spend some time looking past the pandemic and thinking about some of the more obvious risks to which your portfolio might be exposed in the months and years to follow.
Here are several topics to consider, along with a number of suggestions regarding how you might respond to those risks and position your portfolio for post-pandemic success.
Risk #1: increased taxes
Ottawa’s parliamentary budget officer (a senior bureaucrat who provides a non-political analysis of the country’s finances) recently suggested that the emergency financial assistance doled out during the pandemic could be north of $330 billion. Keep in mind that the provinces are also running deficits to support people during this difficult time. Obviously, these deficits will have to be paid for somehow, some time. And the main way for governments to pay for things is − you guessed it − to raise taxes.
Governments certainly have a lot of options available to do that; what follows here is a closer look at some of the more obvious possibilities. Of course, when it comes to predicting changes in our tax code, no one has a crystal ball. Some of the following changes may never happen. Or, they may happen at a later date. Or, they may happen incrementally, rather than all at once. No one knows for sure. Keep that in mind as you read through them.
Capital gains tax
In Canada, only 50% of any profit that we make on the sale of an asset is taxable. That rate applies to any investments which we might hold in a non-registered account, rental property, a cottage or vacation condo, or almost any other asset that we might sell. In tax parlance, it’s called the “capital gains inclusion rate.”
Over the years, the inclusion rate has changed by quite a bit. Before 1972, there was no capital gains inclusion rate − gains were 100% tax free. From 1972-1989, the rate was 50%. Then, from 1990 to 2000, it was bumped up to 66.66%. Then it changed back to the current rate of 50%.
Because governments have tinkered with the inclusion rate in the past, some say that there’s precedent for them to tinker with it now. And, indeed, there was a fair bit of speculation and commentary back in 2016 that the governing Liberals were going to raise the rate. It didn’t happen then but, every few years, the subject seems to come up again.
Principal residence exemption
Since 1972, Canadians have enjoyed the ability to sell their principal residence free of tax (prior to 1972, all capital gains on all assets were non-taxable). As real estate prices in many cities have soared since then (residents of Toronto and Vancouver, we’re looking at you!), that tax-free status has led to billions of dollars in paper profits over that time.
Could the government eliminate that exclusion and make principal residence gains exactly the same as every other capital gain? Or, might they introduce an “exclusion limit” on the gains − say, the first $250,000, or $500,000, or $1 million of gains would be tax free, but everything above that would be taxable? Such a structure would be quite similar to what already exists in the United States, for example.
Doing so would obviously raise a lot of additional tax revenue. It could also dampen real estate speculation, which could make home prices a lot more affordable for first-time buyers. On the other hand, it would raise the ire of nearly every homeowner in Canada, of pretty much every age, in pretty much every corner of the country. Not something any government wants.
Income taxes (corporate and personal)
Income taxes are a major source of government revenue: some 50% or so of all money coming into the federal government in 2019 was from income taxes on individuals. So it stands to reason that one way for the government to make up for a fiscal shortfall might be to raise taxes on that major source of revenue.
Well, maybe. The fact is, raising income taxes on individuals often creates a considerable political backlash for any government that tries it. Sure, it’s always possible for governments to nudge up income tax rates, particularly on higher-income earners. But, with marginal tax rates already higher than 50% in several provinces, it’s unclear just how much they could go up from here.
Corporate tax rates are another story. Corporate taxes comprised only about 7% of federal tax revenues in 2019, and there’s probably less backlash involved in raising them. Indeed, such a move has already been discussed by the Biden administration south of the border, and it’s conceivable that federal and provincial governments here could follow suit.
Wealth tax/inheritance tax
A general wealth tax − that is, a tax on an individual’s net worth, rather than on their annual income − seems to be another topic that comes up every few years. Same goes for an inheritance tax: a general tax on estates over a certain value.
As the baby boomers age and leave the workforce, Canada’s total working population declines, which means less government revenue from income taxes. At the same time, all of those aging retirees increase the need for government spending on health care and other programmes. So yes, there’s an argument to be made that a shift from taxing income to taxing wealth makes some sense. Several countries in Europe operate with such a regimen (France, Switzerland and Norway, for example). The U.S. already has an inheritance tax on very large estates (above $11 million or so), and states such as California are openly considering a wealth tax on individuals with more than $30 million.
Such policies would be a pretty stark departure from current tax policy, however. But, because they would theoretically only be applicable to the very wealthy, they’d probably
generate a lot less public backlash (and a lot less economic hardship) than, say, a middle-class income tax hike or a bump up in the GST, for example.
Tax on registered accounts (RRSPs, RRIFs and TFSAs)
Despite perceptions and rumours to the contrary, there are actually very few legitimate tax shelters available to Canadians. But some of them are of extreme importance to most snowbirds: the RRSP (and its close cousin, the RRIF) and the TFSA. Both of these investment accounts allow individuals to compound their savings free of tax as long as that money remains within the account.
One way for the government to increase revenues might be to “tweak” how much tax is sheltered by these accounts. Perhaps by giving RRSP-holders less of a tax refund when they contribute to their account. Maybe by accelerating the rate at which RRIF-holders are forced to withdraw from their plans, or increasing the amount which they must withdraw in any one year. Or, perhaps, by changing the tax-free savings account to a “mostly tax-free” savings account, with a nominal tax charge upon withdrawal, or something similar.
Are such changes likely? Well, anything is possible. But the political fallout of such changes would be swift and enormous, particularly for any government that tried to enact such changes without trying a lot of other strategies to raise revenues first.
WHAT TO DO ABOUT IT: monitor and seek professional advice
It’s understandable that retirees and others want to know what to do about the above possibilities. Unfortunately, it is far too early to say what (if anything) you should do about them. As scary as some of the above tax changes may seem, it’s simply not wise to base present-day decisions on guesses about what Ottawa might or might not do. What if you sell a long-held asset proactively now, because you think that it’s a smart way to avoid a potential capital gains tax hike next year? If you’re wrong, you may end up paying a whole whack of tax which you would never have had to pay. Or, what if a subsequent government rolls back the tax hike a year or two later?
If you’re concerned about the possible impact of tax changes on your portfolio, the best thing to do is to monitor the ongoing discussions and debate about proposed tax changes, and then talk to a qualified tax professional. A professional accountant or tax lawyer can do an honest and clear-headed assessment of how much of a risk these “what ifs” really are, and how they might affect you, given your personal financial situation. They can also plot a viable (and legal!) way to minimize your exposure to any new taxes that may come to pass.
Always remember: taxes are only one part of any investment buying/selling decision. Sure, you need to think about them and, sometimes, dealing with taxes requires additional advice or strategy that an accountant can provide. But taxes should rarely be the only reason you take a particular course of financial action. That’s especially true when it comes to speculation about taxes.
Risk #2: inflation
Inflation has been something of a non-issue for many years now (last year, it was a whopping 0.6%). But most of us are old enough to remember when this wasn’t the case. Think back to the late 70s and early 80s, when inflation soared to more than 12% a year which, in turn, led to interest rates going sky-high too. Remember how fun that was? (Spoiler alert: it wasn’t.)
Are we going back to those days? Probably not. But, as governments have spent an enormous amount of money attempting to support out-of-work Canadians and pull the economy out of a COVID-related recession, there are some very good reasons to believe that inflation will rise from its historic lows. Add to that the pent-up demand for all of those things that we haven’t been able to spend money on for the past 18 months or so (think airfare, or hotels, or even restaurant meals), and you can certainly make a reasonable case that prices of basic goods and services are likely to rise as demand goes up. That’s just basic economics.
For snowbirds, rapidly rising inflation can be a real risk, particularly for those on a fixed income, with limited ability to give themselves a “raise” to keep up with the rising cost of everything during retirement.
WHAT TO DO ABOUT IT: take steps to protect your portfolio now
There are a lot of different opinions about what investors should do about inflation: some experts are absolutely sure that rising inflation is in the cards, while others suggest that the structure of the economy is vastly different in 2021 than it was in, say, 1981 for example, and that inflation won’t be much of an issue going forward. Until we know which side is correct, it makes sense to take some simple steps to protect your portfolio now.
If you haven’t done so already, it’s probably a good idea to shift at least a portion of your portfolio toward inflationary scenarios. Depending on your tolerance for volatility, that could mean starting a small position in traditional inflation hedges such as commodities and gold, which have performed well during inflation in the past. Real estate is another option − property owners can typically pass on rising costs to tenants by raising lease prices. As can be dividend-producing stock in typically defensive sectors such as consumer staples or healthcare. Such companies will likely have the ability to pass on price increases to customers, regardless of what inflation does in the future.
Risk #3: climate change
By now, you’ve heard plenty about the threats of climate change. The scientific consensus is pretty clear that the climate is indeed changing. And the political consensus seems to be getting equally clear that we will all have to adapt and change along with it.
After the world puts the pandemic behind it, climate change will probably be the most significant economic challenge that the world will face. You can probably think of plenty of examples of how climate change will completely disrupt the way in which the economy works, and how business is currently conducted. Car manufacturers are shifting their product mix to electric vehicles, for example. Some jurisdictions are prohibiting the installation of natural gas appliances, for example. The price of home insurance in climate-vulnerable areas (flood zones; forest fire zones; hurricane zones) is already going up. And on and on.
For investors, the risk of climate change isn’t so much that businesses will have to adapt and change (change is nothing new in business). Rather, it’s the continued disruption of standard investment strategies and portfolio risk models while businesses go through the process of adaptation and change. Will high-dividend-paying oil companies or pipelines be viable income investments for retirees going forward? What about the many resource companies that are the backbone of the Canadian economy − should Canadians start diversifying more of their portfolio because of the potential risks posed to miners, forestry companies and the like? Are retirees taking on too much if they put their money into companies that rely too heavily on the “carbon economy”?
WHAT TO DO ABOUT IT: consider risks and opportunities
Unlike many other risks on this list, climate change is not an imminent risk: adaptation and change will happen slowly (in some cases, painfully slowly) over many years. But, if you’re going to be relying on your portfolio for income for several decades during retirement, it makes sense to think about these risks, and come up with a way of adapting and changing your portfolio as the world adapts and changes around you.
Of course, you should keep in mind that climate change isn’t only about risks. There will be opportunities too. Electric vehicles are an obvious example. Or, the explosive growth of renewable energy. Looking further out, there may be opportunities in the management of water, or lithium mining (lithium is a major component of electric batteries), or “cellular agriculture” (plant-based proteins, for example). When thinking of adapting your portfolio, it makes sense to think of these new “green” investment opportunities as much as it does some of the risks.
Risk #4: currency war
The phrase “currency war” sounds so dramatic. But it’s not a bad way to describe the battling and jockeying for advantage that governments sometimes do in an effort to gain a competitive edge in the winner-take-all world of global trade.
As countries around the world look to rebuild their economies after the pandemic, it’s entirely possible that we’ll see many of them attempt to weaken their currency by increasing government spending, by boosting the supply of money, by cutting interest rates or by outright currency trading in the open market. Such moves help make exports cheaper and imports more expensive, which is sometimes seen as a way of boosting economic growth and employment. These are big benefits after such a long period of economic uncertainty.
The problem is that when a lot of countries try to take the same actions all at once, it can cause tremendous uncertainty for global trade, with increasing tit-for-tat tariffs and trade barriers. That can actually harm local manufacturing and export sectors − exactly the opposite of the intention.
Whether a full-on currency war breaks out or not, massive fluctuations in foreign exchange rates can be a serious issue for snowbirds. If the exchange rate between the U.S. and Canadian dollars fluctuates wildly, for example, it could make going south for the winter a whole lot more expensive.
WHAT TO DO ABOUT IT: average in on currency purchases
Currency movements are notoriously difficult to predict − even the experts can be humbled by all of the different factors that make a given currency go up or down in value. The simple fact of the matter is, short of delaying or postponing your overseas travel (and, after the pandemic, who wants to do that?), the best thing that you can do is to try and smooth out the potential impact of currency fluctuations.
By “averaging in” and buying incrementally over a period of several months, you can make the most of the ups and downs that come with currency movements, and manage the emotions that can affect us when we purchase a volatile commodity such as currency in a time of continued uncertainty.
We’d be remiss if we didn’t mention that the Canadian Snowbird Association has a bulk-buying currency purchase program which offers better rates than your usual bank. Every month, the CSA posts an online chart that compares their rate to three other financial institutions − you’ll see that it’s consistently better by a couple of cents. Keep in mind that the break on the transaction fees which the banks charge can make the savings even better.
Risk #5: market correction part 2
Let’s face it: a market correction, or an out-and-out downturn, is always a risk for retirees. And, while most market watchers don’t expect a sudden plummet like the one in March of 2020, nobody knows for sure what the market will do (or not do) in the short term.
In actual fact, there are several threats on the horizon which may end up causing a downturn. We discussed inflation above: if prices for everyday goods and services rise too fast too soon, consumers might cut back on their spending, which could trigger another recession. Another trigger might be the changes forced upon some businesses throughout the pandemic − some will find it hard to adjust to new economic realities (will office-tower owners survive the work-from-home trend?), or even compete with businesses that have expanded rapidly throughout the pandemic (will anyone shop in malls anymore after a year of buying things online?). And, of course, continued political polarization in the U.S., or a “new cold war” between China and the West, are problems about which the market is always worried.
Perhaps the biggest threat, however, is simply that equity markets have seen an incredibly impressive run since the start of the pandemic. At time of writing, North American equity markets (particularly tech stocks) are hitting all-time highs and are rather expensive by any traditional measure. It may be time for equities to step back a bit after such a big rise.
WHAT TO DO ABOUT IT: trim back exposed sectors
We’re not big on making market predictions. It’s difficult − if not impossible − to consistently and accurately predict exactly what the stock market or the economy will do in the short term. That said, common sense should tell us that going “all in” on stocks at the current moment might not be the wisest move.
Perhaps the best thing to do right now is to diversify, and prepare for volatility. We’ve talked about the subject of defensive positioning and volatility in detail in several previous issues of CSANews. But a good starting place would be to trim back on sectors and stocks that have seen a dramatic rise since the start of the downturn. Technology stocks are an obvious first choice here, and certainly “concept” stocks (electric vehicle manufacturers, for example, or perhaps marijuana stocks) fit the bill, too.
If your allocation to North American equities is high, then perhaps spreading some of your portfolio to other parts of the world (think Asia and Europe) might be a good idea. Cutting back on speculative “high risk, high return” ideas might be a good idea as well − they’re often the ones that get hit the hardest in any downturn or volatility.
Risk #6: focusing too much on risk
Perhaps the most significant risk of all. With all of the financial challenges and economic difficulties that the world has faced over the past year or so, it’s become very easy to feel negatively about the various financial risks which we may face. Simply put, the mental effect of all of this “lockdown” may be a permanent bias toward pessimism, even after the pandemic is over.
But, allowing your concern about risk to overwhelm your ability to adapt to change or plan ahead, or becoming paralyzed regarding making investment decisions while you “wait out” whatever challenges you see on the horizon − that would be a mistake. Focusing too much on risk can prevent us from taking advantage of opportunities that still exist in the market.
WHAT TO DO ABOUT IT: get some perspective
Thinking about risk will always be an essential part of the investment process. And, it bears repeating: the best investors in the world have made it a habit to constantly think about risks, assessing and evaluating the various possibilities and “what ifs” that lie behind every investment. But they keep risk in perspective. They know that there is no such thing as 100% certainty when it comes to investing. We can manage risk, not eliminate it altogether.
The really successful investors have also figured out a very important lesson: that focusing too much on “glass half empty” thinking can distract us from what’s truly important in life. Things such as our family, our personal interests and our health. That’s a lesson worth learning.
Above all, remember this: money and investments will always be a vital part of our lives. Even more so when we reach the age at which having enough money gives us freedom to pursue our dreams, live life to the fullest, or cross items off of our “to do” list. But money should never be the most important part of our lives. Keep that in perspective as we move out of this difficult time, and into what comes next.