2014 Federal Budget: Underfunded Pension Plans in Canada - A greater opportunity!

The 2014 Federal Budget was announced this week with no new surprises… But the one that has us very interested is in changes to the Pension Transfer Limits coming from Underfunded Pension Plans! Under the Income Tax Act, the pension transfer limit formula determines the portion of a lump-sum commutation payment from a defined benefit Registered Pension Plan (RPP), received by a plan member who is leaving the plan (I.e. Retirement), that may be transferred to a RRSP on a tax-free basis. The amount in excess is taxable in the year it is received. In 2011, the government introduced a special rule that provides relief to members leaving a pension that is underfunded. Essentially the transferable amount is calculated in certain circumstances to allow a member leaving an RPP whose estimated pension benefit has been reduced due to plan underfunding. This allows for a greater amount to be transferred to an RRSP. (Budget 2014 proposes to allow this rule to apply in additional situations, including the windup of individual pension plans.) Why should you care? A quick look at the DBRS website will give you a list of the "worst-funded defined-benefit pension plans" in the country: Some quick examples: Ontario Power, Air Canada, Hydro-Quebec, Bombardier, Imperial Oil, BCE, Hydro One, Telus, Suncor Energy, Sask Power, Bank of Nova Scotia, CP Rail, CN Rail, Manulife Financial, ATCO, RBC. ----We have developed a unique team of experts who specialize in stress-testing underfunded pension plans for clients across the country. We run multiple opportunity-cost analyses to provide you with the best information possible to answer the question: Do I take the pension or take the commuted value?---- The more information you have, the better off you will be. Best Regards and Safe Investing! Eric

Equity pullback may be overdue, but piles of cash on the sidelines should provide downside support.

Equities

: Even as more and more Wall and Bay Street strategists wave cautionary flags about the near‐term prospects for equities, the most common question the PAG Equity desk receives these days is “My client’s cash weighting is too high… what stocks would you be buying right now?” Strong YTD performance and a lack of investment alternatives continue to drive funds flows toward the equity market, the U.S. in particular. We’re seeing “frothy”, “bubble”, and “overvalued” more frequently in the media nowadays, but these are not adjectives we would ascribe to equity markets because all of these imply that a sharp correction is in the offing.

Equity markets may indeed be overdue for a pause, but with the outlook for global growth improving, tail risk declining, and headwinds facing most other asset classes (such as fixed income and commodities), we expect any pullback to be modest and relatively short

‐lived. Capital markets will remain focused on Fed tapering, with November’s employment report (due Dec. 6) being a critical piece to the tapering timetable. Investors with

short investment horizons should consider selective profit‐taking with an aim of reinvesting after a modest pullback.
Regionally, we continue to view the risk ‐reward proposition offered by European equities as

attractive. To our U.S. neighbours, we wish you a happy Thanksgiving and we give thanks for a spectacular performance YTD! Looking ahead to 2014, we aren’t expecting an encore performance… U.S. equity returns will likely come solely from earnings growth (consensus forecast calling for 11% YoY earnings growth for S&P500 next year).

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Fixed income: We continue to see merit in our broader macro view, namely that bond yields will likely rise but that the pace will likely be more steady and incremental, with smaller bouts of data dependent volatility. Our view is predicated on (1) that the Fed is now likely to have greater continuity with the general tone of a Bernanke led Fed as Janet Yellen’s confirmation was referred to the Senate, (2) any asset paring will likely be met with other accommodative action, whether that be a change in forward guidance or other market operations, (3) broader macro growth although tepid, seems likely poised to gain some traction in 2014, and (4)

the more recently dovish BoC tone will continue to figure prominently in market sentiment. Although key risks remain, particularly in relation to U.S. political developments, bond yields seem increasingly likely to remain range bound but with a modest upward bias in the near term. As well, the front end of both US and Canadiancurves have been demonstrating more buoyancy which we believe will continue for the foreseeable future.

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Preferreds: The preferred share market has found its groove as it has started to trade in a sideways fashion.  With two rate reset redemptions occurring Dec 31, 2013 (GWO.PR.J and IAG.PR.C), the search for reinvestment ideas continues as investors flock to the good quality (Pfd ‐2L and above) rate resets with attractive spreads as well as bank perpetuals, which is keeping the market well bid. We are anticipating that this trend will continue as we get through tax loss selling and into 2014 when there should be further redemptions in the rate reset space.

Capital Markets

: Is quantitative easing the next step for the ECB; How about them banks, eh?

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After unexpectedly cutting interest rates to 0.25% on Nov 7, economist Nouriel Roubini (a.k.a. Dr. Doom, famous for predicting the U.S. housing collapse and ensuing worldwide recession) recently suggested that the European Central Bank will soon resort to quantitative easing as Europe flirts with deflationary risks. Combined with an inflection in some economic data, the potential for quantitative easing further supports our interest in European equities.

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Strong share price performance by the Canadian banks is threatening to overtake hockey as the most popular armchair sport in Canada. Driven by increasing comfort in a soft landing scenario for housing, forward P/E for the bank group has expanded by 1.8 multiple points since June to 11.5x. Under normal conditions, Cdn banks have traded in the 12x ‐13x range. All you kids out there, stay tuned for Earnings week in Canada that kicks off next week; current consensus is pointing to 9.8% YoY earnings growth for the group.

 

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Bank of America is the latest to forecast further downside risk to gold in 2014. BofA sees gold hitting US$1100/oz next year as the Fed begins to taper and the U.S. dollar appreciates. BofA expects oil, copper, and natural gas to remain range bound. UBS cut its one ‐ and three‐month gold price forecast to US$1180/oz and US$1100/oz, respectively.

Economics

: Recent data supports early‐2014 Fed tapering; Canadian economy moderating

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Recent U.S. housing and employment data continue to point to possible Fed tapering decision in January or March 2014. While November’s jobs report (due Dec 6) will be the most important data point between now and the next Fed meeting (Dec 18), weekly initial jobless claims have shown promising trends in recent weeks  (4‐week avg declined to 332k vs. 358k at the end of Oct).

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U.S. Housing data has been mixed, with October existing home sales continuing to slide (5.12M vs. 5.14M est 5.29M in Sep) and the mood of U.S. homebuilders remains below the peak in August. Average home prices, measured by S&P/Case Shiller, continue to show strong uptrend (Sep +13.3% YoY vs. +13% est). October’s building permits, which tend to foreshadow housing starts, reached a five ‐year high (1034k vs. 930k est). There are two ways to interpret this strong reading: there is pent up housing demand from ongoing employment

gains, or that the drop in mortgage rates after the September FOMC meeting spurred activity. Unfortunately, the most important housing data, housing starts, has been delayed until Dec 18 due to the Oct government shutdown. In our opinion, the U.S. consumers’ ability to cope with higher mortgage rates is critical to the tapering equation.

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Canadian data showed moderating consumer trends, with Sep home prices gains slowing (+1.6% YoY vs. +1.7% est and +1.8% in Aug), decelerating Sep ex ‐auto retail sales (0% MoM vs. +0.2% est and +0.5% in Aug), and Oct headline inflation slowing further (+0.7% YoY vs. +0.8% est and +1.1% in Sep). Weaker data has contributed to a 1.5% drop in the C$ so far this month. We expect headwinds for the C$ will likely extend into 2014.

Geopolitical

: Tentative breakthrough with Iran; China trickling out reforms

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Western nations reached a six‐month interim agreement with Iran regarding the latter’s nuclear program. Under the terms of the agreement, Iran has committed to stop enriching uranium beyond 5% and grant access to inspectors. In return, no new nuclear ‐related sanctions will be imposed on Iran for six months and Iran will receive up to $7B of relief on existing sanctions. Should Iran live up to its commitments under this confidencebuilding first step, further relaxation of sanctions are likely, including a possible loosening of oil export restrictions. After an initial knee ‐jerk reaction, Brent crude oil prices have recovered as traders take a wait‐andsee

approach.

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China has started to trickle out reform decisions reached at its recent planning session. While precise details have yet to be disclosed, easing of the controversial one‐child policy, dismantling of some state‐owned entities, removal of roadblocks for capital raising, and liberalizing the financial system’s ability to set interest rates are among the reforms announced to date.

(Portfolio Advisory Group - 2013 Year End - Here's What We're Thinking - Forum) - E

The "Great" Rotation into Fixed Income?

I wanted to share a recent article covering Barron's recent round table discussions on Fixed Income and investment trends.

An even greater rotation into fixed income? Quite a thought, as we're constantly being told that the opposite is occuring... But let's look at the bigger picture.

Every day, more than a thousand Canadian boomers turn 65. The trend is expected to continue for the next 17 years. And as they enter into the drawdown period, they're looking for ways to turn their nest eggs into retirement income.

This has resulted in the need to fundamentally shift their asset mixes, Rick Headrick, president of Sun Life Global Investments, told a lunchtime audience at an advisor event recently.

"In 2000, 70% of portfolio holdings were sitting in equities, while only 14% were in the income categories," he says. "Today 44% is allocated to fixed income."

The other major investment trend, he adds, is corporate-class bonds. For non-registered assets, it's a tax-efficient way to draw income out. In fact, last year, the bulk of net flows into corporate class were allocated to fixed income.

So for all the talk of the great rotation into equities, current flows suggest if there's any rotation, it's into fixed income.

"Equity funds have been in net redemption each of the last four years," says Headrick. "Certainly there's been a flight to safety as well, but it's also because of that thirst for yield."

Corporate class' first major advantage is the ability to switch between funds within the structure. If you wanted to trim your Canadian equity weighting, and move more into emerging markets, you could do that within corporate class without triggering a tax event.

Another big advantage: efficient taxable distributions. A corporate mutual fund company can pay out Canadian dividends, which are taxed more favourably than interest income or foreign dividends. Also, on redemption, only 50% of capital gains are taxable.

The structure can cancel out gains and losses for tax purposes. (If you have one fund sitting in a gain position and another in loss, they offset each other.)

But these advantages can come at a cost.

Corporate class fixed-income funds have higher fees relative to the mutual fund trust version. But that's ok because tax efficiencies more than offset those higher fees.

Headrick notes another wrinkle in the form of the disconnect between investors' risk appetite and their return expectations:

"Currently only 22% of investors are willing to take on more risk to get a higher return, yet 40% expect their investments to yield 5% to 7%, he says.

That means the traditional asset mix of fixed income and Canadian equities won't cut it.

"Investors need to diversify into infrastructure (toll roads, airports, etc.), real estate, emerging market debt and other non-traditional asset classes to create sustainable income in retirement," he asserts.

Something that we tend to fully agree with.

Please give me a call/email if you would like to discuss your current asset mix, investment policies, or to review what options in the non-traditional space are available to you.

Best Regards and Safe Investing!

Eric

Recent market volatility isn’t necessarily all bad news…

Recent market volatility isn’t necessarily all bad news…

With the end of quantitative easing in sight, we remain optimistic on equities and concerned about bonds:

• On June 19, Ben Bernanke and the members of the Federal Open Market Committee (FOMC) signaled the tapering of bond purchases by the U.S. Federal Reserve.
• The statement triggered the biggest two‐day decline in stocks in the last few years. However, in our view, the tapering of bond purchase means that the economy is improving. If the economy is improving then that will be good for corporate earnings and therefore good for stocks and commodities, and bad for bonds and gold.
• We believe the correction we have been expecting is currently underway and this will soon represent a good buying opportunity. We remain optimistic on the outlook for equities, continuing to prefer the U.S. over Canada for the balance of 2013.

Tapering is coming:

• The increase in bonds yields after the June 19 FOMC statement was no surprise as one of the largest buyer of bonds since the recession has just signaled their intentions to slow down the purchases and possibly end the purchases in 2014. With increased borrowing costs due to higher interest rates, the cost of borrowing is outweighing the benefits of holding stock positions with borrowed money and therefore funds that buy stocks with borrowed money decided to sell their stock positions and payback their loans.
• Global equity markets have been declining since Fed Chairman Bernanke’s testimony to Congress on May 22. In this testimony, Bernanke made it clear that the FOMC “is prepared to increase or reduce the pace of its asset purchases to ensure that the stance of monetary policy remains appropriate as the outlook for the labor market or inflation changes.” This 1‐2‐3 punch triggered sharp declines in virtually every asset class, except the U.S. dollar.
• Broadly speaking, improving economic trends bode well for corporate earnings growth, and with valuation still attractive, U.S. equities remain our favourite asset class. In this environment, our preferred U.S. sectors remain Financials, Industrials, Technology, and Healthcare. We expect some additional softness for Telcos, Utilities, REITs, and Consumer Staples.
• Gold has succumbed to the fact that inflation around the world remains subdued and that the U.S. could soon stop “printing money.” Copper and other base metals are flirting with technical support levels as investors re-evaluate China’s economic growth.

U.S. still on recovery path; China’s recovery may be delayed

• Recent U.S. economic data has been mixed but still supportive of an improving trend. Retail sales for May, which provide tangible evidence of improving consumer confidence, were better than expected. In sharp contrast to the U.S., Canadian April retail sales were weak and declined when auto sales are excluded. Headline inflation for May was also lower than expected.
• After weak trade data earlier this month, Chinese manufacturing activity showed further contraction. Based on recent commentary from the new leadership it appears that they are comfortable with the current level of economic growth (7%‐8%). Furthermore, the new leadership has voiced a preference to move the country toward a sustainable growth model by focusing on financial, social, and environmental reforms, and a gradual transition away from an export‐centric economy to a domestic‐centric economy.

Risk on / Risk off...........

Summary of FOMC statement: Bernanke hinting that QE nearing an end, but action remains data-dependent

1.       Change in statement:

a.        Previous: “The committee continues to see downside risks to the economic outlook.”

b.       Today’s statement: “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall.”

2.       Key Bernanke sound bites relating to tapering of QE:

c.        “If the incoming data are broadly consistent with this forecast, the committee currently anticipates that it would be appropriate to moderate the pace of purchases later this year,”

d.       “And if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

e.       “If you draw the conclusion that I just said that our policies -- that our purchases will end in the middle of next year, you’ve drawn the wrong conclusion, because our purchases are tied to what happens in the economy. If the economy does not improve along the lines that we expect, we will provide additional support.”

I wanted to share some of our Chief Investment Officer's comments regarding the current market reaction to the above:

After yesterday's press conference from Mr. Bernanke it is clear that the market is back in risk-off mode but we ask the question why are all asset classes moving in the same direction and on the surface the only safe place to be looks like cash????

  

Mr. Bernanke signaled that should the economy continue to improve then the Federal Reserve will start to taper the Quantitative Easing that we have seen over the past few years or in other words they would slowdown their $85 billion per month bond buying and eventually end the buying sometime by mid-2014. This potential tapering has been talked about since Mr. Bernanke mentioned it at the Senate and Congressional hearings in late May and the markets have seen a pull back since that meeting especially when we look at 10 yr bonds in the US. With his confirmation of such at yesterday's press conference the markets have continued their risk-off activity. However, we ask the question if the economy is improving why are the stock markets declining rapidly???

  

As we are all aware the High Frequency Traders control the markets these days and with stocks in a selling phase these High Frequency players exaggerate the problem. So why the sell-off at all?? Well it's called the carry trade and for those of you that have been around long enough I am sure you will remember the great unwind of the Yen carry trade. Basically Investors borrow money at low interest rates and buy stocks, as interest increase the cost of the carry increases and therefore investors are forced to sell stocks and payback the loans. We expect this unwind to continue for the next few days!!!!!

  

So what is going to happen over the next few months?? Volatility and lots of it!!! What Mr. Bernanke has done here is increase the odds of extreme volatility around economic releases as he clearly noted tapering will be data dependent. We expect that the market is going to be thrown around on a regular basis here as Housing and Employment numbers are improving yet Manufacturing and overall Growth remain subdued. -SJ.

This correction was an overdue and welcome event in my opinion. We've been watching the margin levels of investors continuously increase over the last year, mostly on the back of continued QE... The forced covering will bring asset prices back to more normalized levels, and the potential for long-term fundamental investing can resume.

Hold firm to your disciplines. Be proactive, not reactive. Conviction is key.

Regards.

E

"Since WW2, investors have endured a total of 56 pullbacks, 19 corrections and 12 Bear Markets."  (S&P Capital)

Selling Your Business? Planning is key........

One of the core pillars of our practice is in working with business owners in and around Calgary. We have been assisting them with proper succession planning, valuation, tax savings strategy, pension and income planning, family security, and eventual estate optimization for a number of years now. In preparation for our fall series for business owners, we will be posting articles and tips that cover some of the key aspects of a succession plan, starting today with Estate and Tax:

In many cases, the owner of a small business wants to pass the business on to succeeding generations, typically children. This can be done through a Will when the person dies but the person may want to do this while they are still alive. There can be compelling tax reasons to do this. An 'estate freeze' is a mechanism where ownership passes to the next generation while the owner is still alive. Here are the different types of estate freezes:

Paying Tax Now

Under tax law, if an asset such as a company is transferred to another party, either to family member(s) or another arm's length party, it is considered to be a sale at the fair market value. This can result in substantial capital gains tax in the year of the transfer if the company has increased in value. However, if you transfer now, any subsequent growth is attributed to the new owners.

Use of Trusts

One way to do an estate freeze is to have the shares of a company transferred into a trust with family members as the beneficiaries. You may be able to establish yourself as the trustee and retain control but if the beneficiary of the trust is not your spouse, you will have to pay capital gains tax since the transfer will be as if you sold the shares. Again, tax on any subsequent growth in the shares is the responsibility of the trust and/or the beneficiary.

Section 85 Rollover

In the previous two examples, there may be immediate tax implications by transferring a company to your family now. A further issue that can arise is that the owner will lose control of the company. The Income Tax Act provides a mechanism that allows an effective change of ownership while still enabling the original owner to maintain control of the corporation. This is the Section 85 rollover.

The Section 85 rollover can be a very practical and tax efficient strategy. However, it can also be rather complex in the details and is another area where professional advice is highly recommended.

Situation:

Lori Strong wants to pass her wholly owned company, Lori Inc. to her two children, Sarah 34, and Chris 32. Her shares of the company have a cost of $1 million. A qualified business valuator has determined the current fair market value to be $5 million so the shares have increased in value by $4 million.

Setting up a Holding Company

A Holding Company, Holdco Inc, is set up. Sarah and Chris are equal shareholders and they each buy 100 common shares for $1 per share.

Using Section 85, the shares of Lori Inc, are transferred into Holdco. In return Lori receives preferred shares of Holdco worth $5 million, the fair market value of the Lori Inc. shares. These preferred shares have voting control over Holdco and are retractable at Lori's discretion, which means she can redeem them for $5 million. Lori can choose a transfer value for the shares of $1 million - her cost. Lori will not have to pay any tax on the preferred shares until she eventually sells them.

Since the preferred shares have a set value of $5 million any subsequent increase in the value of the Lori Inc. shares will accrue to the two common shareholders of Holdco Inc., Sarah and Chris.

By doing this, Lori has managed to keep control of the company, deferred any immediate gain, and has passed on any subsequent growth to her children.

One of the important features of the Section 85 rollover is that Lori will have discretion in regards to the transfer value of the Lori Inc. shares. For example, although the shares currently have a fair market value of $5 million, under Section 85 she may be able to transfer the shares at their cost of $1 million, avoiding any immediate tax since the transfer amount chosen ($1 million) is the same as her cost. The children would have a tax cost of $1 million for the assets (the shares transferred) and the owners of Holdco Inc. shares (Chris and Sarah) will not have to pay any tax until they dispose of the Lori Inc. shares in the future.

Your advisor will be able to provide you with additional general information on Section 85 rollovers and how to proceed if it appears that this strategy would be right for you.

Be sure to update any other documentation that may contain information related to your company, such as the information contained in this personal record keeper and personal and financial log book. Share your personal record keeper with your loved ones including your Executor or Executrix. Provide a copy of your personal and financial log book to your financial advisor so that he/she can have a better understanding on how your financial situation is changing.

Once a month I will be putting up key articles on Business Succession Planning in preparation for our fall series of luncheons on the subject.

*Please forward this on to anyone you know who may be going through the motions of selling or succeeding their businesses in the coming years. (*Early planning is key.)

Or, if you have any questions, or if you would like to meet personally to have a discussion, shoot me a message.

Best Regards.

Eric

Private/Public Capital Trends in Oil and Gas...

I want to share with you some key thoughts from our friends at Arc Financial. They are an energy group we work with from time to time, and they put out some very good commentary on energy markets. I felt that their most recent publication warrants some consideration, as it mirrors comments made by the CEO of Pengrowth during a boardroom meeting we had 2 weeks ago: The trend of US private equity and pension funds moving to acquire small-cap public oil and gas companies.

"A Privileged Trough of Capital Reflects Change"

They say, "you can lead a horse to water, but you can't make it drink."

There are exceptions to this proverb, notably for oil a nd gas companies. We know if you lead them to capital they will always drink. Unless the trough is dry.

Right now there is unprecedented scarcity of public capital available for oil and gas companies. Year to date Canadian financings for the industry are at a 10-year low, and probably at an all time low if the data is adjusted to reflect a growth metric, for example dollars available per unit of output. The dearth of dollars is, in part, due to the mood of the capital markets, but mostly the situation speaks to the changing structure of the industry.

After flipping the 2013 monthly calendar twice, year over year public company financings to date are tracking around 20% of normal. As of early March, total equity raised is at $345 million, which is a mere trickle. Usually by this time of year new equity issues are indicating one and a half to $2 billion, well on the way to the 10-year average of about $10 billion per year. Debt too is lagging: only $275 million has been issued this year.

It's not unheard of for the debt and equity spigots to be shut. It happened in 2002 after Enron imploded. IT also happened on rare occasion in the 1990s, but back then the industry was one-fifth the size that it is now on a cash flow basis. Also, since then, acute inflation in the mid-2000s devalued the purchasing power of an investment dollar.

Today the capital markets are demonstrating extreme discretion. ALthought broad equities have perked up recently, risk aversion is still top of mind among investors. IN Canada, intertwined macro oil and gas issues like price differentials, low prices and access to markets are also causing reticence to finance public companies in the industry.

WHile debt and equity are important lifelines, the dominant source of investment capital is cash flow. Unless dividends are being paid out, oil and gas companies typically reinvest every dollar of cash flow back into the ground. But on the natural gas side of the business this source of capital is also scarce due to low continental commodity prices. On the oil side, cash flow is compromised due to deep price discounts. Historically, this three-way choking off of industry capital - equity, debt and cash flow - would reflect negatively on the industry, leading to a serious contraction of field activity and ultimately production declines.

Drilling activity is somewhat muted this year, but not proportionally to the dearth of public capital. Our estimates suggest that the industry will still spend $54 billion in 2013, this despite a forecast of only $36 billion from cash flow. How is this reconcilable; in other words, how can the industry as a whole be spending 1.5 times its cash flow without help from public capital markets?

The gap is explainable by prevailing structural changes. First, private equity capital has stepped in to fill in for some of the public market shortfall, but not all. Globally, the institutional investors bias is leaning toward private company investment. Private equity has financed several hundred million dollars already in 2013, but this quieter source of capital is highly selective and doesn't serve up growth capital to the broader industry.

Selectivity and discretion is a big theme in today's investment landscape. Only a handful of high-growth, darling companies are able to raise money; for example, two-thirds of the $345 million in equity this year was raised by one public company - Tourmaline OIl Corporation.

The loudest statement about structural change comes from the patient and deep pockets of large multi-national companies, there the bulk of the industry's growth capital is coming from right now. None of these participants need to depend on public market financings to further their interests. Shell, Chevron and PETRONAS are declared long-term players in the LNG game, spending money from wellheads to the coast, regardless of current market conditions. Overseas JV money targeting resource plays also continues to be an alternative source of capital. Notable, big oil sands companies are tracking spending levels in the low-$20 billion level this year, with no hiccup relative to prior years.

Massive up front investment into big resource development is how the industry will end up spending significantly more than its cash flow this year; the oil sands sector will spend 250% more than it takes in, and non-oilsands 120%, for a weighted average of 150% as a whole.

Structurally, the selectivity of capital and shift in its sources means that the oil and gas industry has become a cloistered business that favors few. In fact, there is lots of water at the trough. But for now only big, sophisticated or privileged horses are able to drink. ( Peter Tertzakian - March 22, 2013 - Arc Financial Corp.)