The Dead Money Syndrome
Are Canadians being encouraged to save too much?
May 6, 2015
How often have you heard someone say they have lots of investments but are cash poor? Or, perhaps you know of retirees who are having trouble meeting their basic monthly cash needs but live in homes which are bigger, require more work and cost more to maintain than can comfortably be managed. Even the government, in talking about retirement income, understates the value of personal savings and other non-financial assets held by most Canadians (the 4th Pillar of the retirement system).
These are examples of the “dead money syndrome”: having assets that don’t provide a regular or sufficient cash flow. ‘Dead money’ is a common phenomenon. Wall Street defines it in broader terms – investments that are not expected to appreciate past their current price.
Holding investments in stocks or bonds etc. that have appreciated or depreciated significantly is understandable if the investment is likely to appreciate or if disposing of the investment results in a large amount of taxable income. Keep in mind you can’t avoid CRA forever: income tax will come into play sooner or later but the impact can often be offset by other capital losses.
Also, remember that when a person dies, capital gains are immediately crystalized and taxable. This can result in the estate having to sell investments at a loss in a down market, to create cash – a common timing issue and risk.
A classic example of dead money is buying a stock for $10 share (say 1,000 shares – $10,000) which pays a 4% dividend ($400 per year where inflation is 2.5%). This was a reasonable return at the time of purchase: the real rate of return is 1.5 % and the dividend receives favourable tax treatment. Over time however the stock appreciates to $20 per share but the dividend rate remains constant or low. The return on the original investment (book value) is still 4% but the effective return on the investment is now is 2%. The real rate of return, assuming inflation is constant, is now negative: -0.5%. In this situation there is a gain of $10 per share ($10,000) on which the investor receives no return – dead money! The same type of example can apply to bonds, real estate, and other types of investments.
A simple test for dead money in a portfolio: divide the annual income by the current market value and compare this return to your target (expected) return.
The difference is the dead money effect.
Less sophisticated investors often like to hold their ‘winners,’ where there are significant gains (or loses) without fully understanding there is a potential cost and risk.
Fund managers are continually confronted with this situation (without the tax issue). Most of them adhere to strict a selling discipline where they crystalize some or all of their gains. In other words, they continually try to enhance their returns by minimizing the impact of dead money. Many investors don’t adhere to a selling discipline often because of an emotional attachment to “winners” or lack of confidence in finding another suitable investment. As a result they forgo the additional cash income that could be generated from dead money.
When planning for retirement many people focus on their investments and on their registered pension plans as well as RRSPs, TFSAs etc. They often overlook other assets such as homes, cottages, motorhomes, vehicles, boats, and coin collections as a way to fund their retirement.
Many people are reluctant to face the fact that there comes a time when, physically and mentally, they may not be able to empty their ‘bucket list’ or perhaps are not interested or capable of managing (disposing) of their assets and financial affairs.
Examples of dead money include unused cabin cruisers, seldom-visited cottages, oversized expensive homes, or collections of coins or salt shakers that heirs won’t really appreciate or sell for what they’re worth. Although the emotional attachment to these types of assets is understandable, the reality is that, at some point, they will have to go.
Also keep in mind that many people chose to pay down their mortgages rather than contributing to their DC, RRSP or TFSA intending the equity in their home as part of their retirement assets (i.e. the sale of their home would be used to finance their retirement).
People also often feel obligated to ‘leave the children something’ when they die. This is a commendable goal but your heirs are unlikely to expect you to “go without’ for their sake while you are alive. They would likely encourage you to do as much as you can while you are still physically and mentally able (if not consider revisiting your will).
Malcom Hamilton, a well known pension actuary, thinks that retired people are reasonably frugal and shouldn’t focus on saving a huge pot of money so they can go into a nursing home. Enjoy life a bit while you still can! After all, most people worked hard to accumulate a bit of wealth.
For the average, unsophisticated, cash poor investor, the hesitating to dispose of assets and re-invest dead money is understandable.
But spending a bit of money and time with an accountant to get an independent unbiased opinion of your financial, estate, and tax situation, may minimize these concerns and encourage you to free up some of your dead money.
The fear of re-investing can also be addressed. Lower risk and cost investments are available (“Remedies for income deficient portfolios”) which could help maximize retirement income.
Emotion, vanity, a lack of awareness, fear of having to make investment decisions, procrastination and clinging to the past are all factors in the dead money syndrome. Hence, many retirees are cash poor and struggling from month to month to make ends meet or limit their activities (e.g. travelling, vacationing, or perhaps a new set of golf clubs etc.).
The slogan of one large Canadian bank sums up the dead money situation nicely: “you are richer than you think.” But you need to act.
A personal anecdote that lead me to write this article. My parents, like many others of their generation, spent most of their lives scrimping and saving to make ends meet. I handed my mother a cheque for a large sum of (tax free) money from sale of her house as she was lying in bed at the nursing home. I asked her what she wanted to do with the money. Her response – “put in the bank – what else can I do with it now”! She died shortly after – but her message was clear to me.
A final sobering thought – there are a few main beneficiaries of retirees who sit with dead money and save, save, save. These are governments (less pressure to improve Canada Pension Plan and/or less likely to have to pay welfare, etc.), the financial industry (record keepers, fund managers and advisors appreciate those on-going asset based fees) and heirs.