Index Funds

In this post I'm going to discuss a type of "mutual fund" that is fairly popular with more educated and sophisticated investors. Index funds are something that are being discussed more and more in todays investment world, especially by those who are not very fond of traditional mutual funds. In this post I'll compare index funds with traditional mutual funds, and try to give the main differences between the 2.

What are Index Funds?

Essentially, an Index Fund is just a Mutual Fund that tracks a specific Index, such as the S&P/TSX Composite Index (Toronto Stock Exchange). An index fund will try to emulate the returns of the index as much as possible, by holding the same stocks as the index itself, and holding the same weightings as each of the stocks in the index.

An index fund will invest in the largest, strongest, and the best known companies in the country/region (and sometimes sectors or commodities) they are invested in. This might offer investors some sort of 'security' in their investment, in the sense that investors will feel that larger companies are less likely to get into financial trouble or become bankrupt or the like.

Management Style

Whereas a regular Mutual Fund will have a mutual fund manager who will buy and sell securities and try to beat the index (known as either professional or active management - depending on the type of fund), an Index Fund will take on what is known as 'passive management'. This is because the Index Fund Manager does not have to do much buying/selling, and his/her job is just to mimic the index as best as possible. Therefore, this requires a lot less research; which will also reduce the overall cost of the fund.

Having 'passive management' means generally there will be no advice from advisors as you would get with traditional mutual funds (therefore no trailer fees paid to the advisor -- which keeps their cost lower). This is why generally Index Funds are used by more sophisticated and educated investors.

Many Index Funds will not be able to fully mimic the index because they will have a 'weighted cap'. This means the fund will not be allowed to have more than x% of one company. For example, at one point Nortel made up more than 35% of Toronto's Stock Exchange, but when it crashed, it took the S&P/TSX Composite down with it. So to reduce the market risk, most Index Funds will have a 'cap' on how much % they can have of one company.

Costs

Since the management of an Index Fund requires a lot less in the way of research, buying/selling, management etc..., this will greatly reduce the costs (MERs) associated with the fund. Where a regular mutual fund can range from about 1.5% to 2.5%, an average Index fund can go anywhere between about 0.4% to 1.4% (depending on the company and the index it is following).

Also, Index Funds are generally bought from on online trading platform or a discount brokerage. This means for every transaction (buy or sell), there would be a charge. Depending on how many transactions are done and how much each transaction is for, this could actually negate any savings from the lower MER. In some cases, the fees associated with trading online will be more than an MER on a regular mutual fund, and thus lowering the overall return of the fund, thus

Risk/Returns

Although an Index Fund will hold the strongest, largest and best known companies in the country/region, they still carry risk (as does any other fund). In fact, often, an Index Fund will have more risk than an average Mutual Fund Portfolio. This is because an Index Fund will track only the Index in a specific region, so it will not give as much diversification as many Mutual Fund Portfolios.

Some will say to balance out risk, to just buy several Index Funds from several different Regions/countries, so to reduce the risk, but that availability of Index Funds for other regions is not as much as for regular Mutual Funds. Regular Mutual Fund portfolios generally have the ability to diversify more than an Index Fund Portfolios, so to reduce the risk. Also, as mentioned above, often there will be a small percentage of companies making up a large percentage of the index, and therefore will make up a large percentage of the Index Fund. This will be more risky than most Mutual Funds, who will have more companies with less weighting, so to spread the risk out.

Generally, Index Funds will have higher returns over a longer period of time, as compared to the average Mutual Fund. Having said that, the volatility is still a lot higher than Mutual Fund portfolios. A Mutual Fund manager will try to match, or even beat the index, with using as little risk as possible. So, although the general returns for Index Funds are higher than the average Mutual Fund, this is not considering the risk involved. If we were to look at the "risk-adjusted returns" (the returns calculating the risk being taken) for Index Fund in comparison to average Mutual Funds, we would find the the returns would actually be fairly similar.

As mentioned before, there is no "one-size fits all" investment or strategy for everybody. Index Funds can be a great addition to an investment portfolio, but only if used properly. Please consult your financial advisor before making any decisions on using Index Funds in your portfolio, and also do your own homework.

I hope you have learned something from this post, and please don't hesitate to contact me if you have any questions!

Critical Illness Protection

In this post I will discuss something that, I think, is not discussed nearly enough by advisors and the general public. We've all heard about and have been swamped by ads of Life Insurance, Auto Insurance, Home Insurance etc..., but I don't think we hear enough of something that may be as important (or if not more important) then the above mentioned. The 2 complimenting products to life insurance for a family 'protection plan' are Critical Illness Protection, and Disability Protection (which I will discuss in another post). In this post I will focus on Critical Illness protection and will help answer several questions about it, such as: What is it? Do you need it? How much is needed? What types of coverage are there? etc...

What is Critical Illness Protection?

Critical Illness Insurance is a type of 'Health Insurance' that provides a lump-sum payment if you were to become seriously ill. It is also given the name "Living Benefits", because you don't have to die to receive the payout. It is considered to be a type of an Insurance to protect your lifestyle, and to help you recover from a serious illness.

Although the illnesses that are covered vary from company to company, you can be covered for most (or all) of the following:

• Alzheimer's disease
• Aortic surgery
• Benign brain tumour
• Blindness
• Cancer
• Coma
• Coronary artery bypass surgery
• Deafness
• Heart attack
• Heart valve replacement
• Kidney failure
• Loss of limbs
• Loss of speech
• Major organ transplant
• Major organ failure on waiting list
• Motor neuron disease
• Multiple sclerosis
• Occupational HIV infection
• Paralysis
• Parkinson's disease
• Severe burns
• Stroke

Do You Need It?

Of course, no one plans to get sick, however, if something were to happen to your health unexpectedly, you want to make sure that your financially prepared to take care of the situation at hand.

While healthy lifestyle choices can be your best defence against some health risks, a critical illness such as cancer, stroke or heart disease can strike anyone at any time. Consider the following:

• One in three Canadians will develop a life-threatening cancer⁽¹⁾.
• One in two heart attack victims are under 65 years old⁽²⁾.
• Each year, 50,000 Canadians suffer a stroke. Of all stroke victims, 75% will be left with a disability⁽²⁾.

(http://www.rbcinsurance.com/healthinsurance/critical-illness-insurance.html)

There are many statistics around about different type of illnesses and the chances of getting them, but the bottom line is that you are far more likely to get a critical illness before age 65, then you are to die. Also, due to medical advances, people are living longer and longer, and are more likely to survive a critical illness then ever before.

To determine if Critical Illness protection is needed, and how much is need, you can do some basic calculations. Basically, what you should do is to determine what your financial hardships would be if you were to become seriously ill. Many things need to be taken into consideration, such as:

- income replacement

- hiring a home-care nurse

- hiring a nanny

- business needs

- debt payments

- medical treatments

- travel

etc...

There are many websites that can help you determine the approximate amount of coverage required, but here's one that I found helpful, from Canada life:

http://www.canadalife.com/003/Home/Products/CriticalIllnessInsurance/CriticalIllnessInsuranceCalculator/index.htm

Types of coverage

Most insurance companies will be able to offer Critical Illness insurance, either as a stand-alone policy, or as a rider (addition) to a regular Life Insurance Policy. Many group insurance policies from work will offer some sort of combo of life/disability/critical illness protection, but in order for you to know what is being offered, please carefully read your group plan package.

Although different companies will offer different products, generally the types of coverage offered would be a 10-year term, 20-year term, to age 65, to age 75, and in some cases to age 100 protection. Often, the 10 year and 20 year term policies are renewable (but be aware, the premium rates upon renewal will usually skyrocket!)

Making a Claim

Making a claim is not as difficult as some might think. What you need is a licensed medical physician (in Canada), who specializes in your illness, to diagnose you with that condition or an illness covered in your policy.

Once approved, the insurance company will pay out a lump-sum payment, usually 30 days after the claim has been put through. The great thing about having a lump-sum payment, is that there is no restriction on how the funds can be used. You can go on a vacation, go to another country for an operation, buy a car, etc...

Also note, once the policy has paid out, the policy is now considered to be ceased, and is no longer active. A bonus is that, even if you recover from the illness, you keep all the funds provided to you.

What if there is no claim made?

In some cases, someone will go their entire life (or most of it) without getting any critical illness (and therefore not making any claim). Depending on the insurance company, some will provide you with a 'premium rebate' addition to your policy, which means that if the policy expires, and you have not made a claim, you receive all your premiums paid into the policy back in full. Also, if a person were to die without making a claim, the premiums can also be returned back to the beneficiary designated on the policy. This is one thing that insurance companies use to to peak the interest of clients.

Critical Illness protection can be offered by any Life Insurance Agent/Representative or can be offered by most Life Insurance Companies directly. As mentioned before, it can be an addition to a regular Life Insurance policy, and if combined, will often be cheaper then getting a standalone policy.

If you are not sure whether this is something that would be beneficial to you, please consult your financial advisor before making any decisions. I hope you've learned something from this post, and if you would like to get more information on this type of protection and the choices available, please do not hesitate to contact me.

Using Insurance as a Charitable Donation

Many of us want to help the less fortunate or want to give back to an organization that has helped us in our lives. I've discussed, in my earlier posts, about using insurance as a means of personal/family protection as well as briefly touching upon the ability to grow money tax-sheltered. In this post I will discuss one of the other uses of insurance, which is using it as a charitable donation.

There are many people in society who either don't have dependents or any person(s) that they want to leave money for after they pass away, but have a favourite charitable organization or religious group etc... that they would love to leave money for. Many are regular donors to these organizations or charities and want to continue their giving even after they pass on. Some people will include the organizations name(s) in their will to have their assets given to one or more of their chosen organizations, but some might not be able to give as much money as they want due to lack of savings or pre-mature death. In cases like this, using an insurance policy as a means of leaving money for a charity/organization can be a great way to do that!

A person can make a substantial contribution to any charity by naming the organization as a beneficiary. Most likely, the amount they leave behind will be larger then any amount they would be able to afford on their own, so it is an easy and affordable way to make a generous contribution at the time of death.

Tax Advantages

There are usually tax advantages when you donate/contribute to a registered charity, and this situation is no different. All proceeds will go directly to the beneficiary, since we know that life insurance policies will pay out tax-free.

Having the tax-free proceeds being paid to the charity is great, but that is something that happens after death, so, what other advantages are there during life? Well, the premiums that are paid can actually be deducted from the annual income as an itemized deduction. So in this way, there are tax advantages both before and after death!

In order for this to be official, the policy's rights actually have to be signed over to the organization, and all the documents be delivered to them. All this means is that, the organization must be consulted before any change to the policy itself.

Other Details

By signing over the policy to the organization (basically making them the owner), the proceeds are not included in estate of the person who has passed away. If the policy is not passed over to the organization, but just has the organization as the beneficiary, the proceeds will be included in the estate's worth, even though the funds will be going directly to the organization. This could result in much higher taxes for the estate and might leave less money for other beneficiaries from the estate (i.e. family).

Other Options

Getting a new insurance policy might be something that is not affordable by everybody, so what other ways can be used to leave money through a policy? One way is, if someone has an existing policy, to have the dividends paid out by the policy (if there are any) to be allocated to the organization itself, rather then re-invested back into the policy (or given as cash). This can be done by contacting the insurance broker or the company who provided the policy, and they can check to see if it is possible with the policy that is already in place.

Another option is to add the organization as a beneficiary to an existing policy, which will still allow to make a large contribution, but won't cause any extra taxes since the existing policy would have been added to the estate anyways -- the only thing that would be done is splitting up where the funds are allocated at the time of death. The amount of donation given can actually be deducted from the gross estate of the person who has passed away (there will be a charitable donation tax credit for the amount of contribution), which is something that would benefit the heirs of the estate. However, using this option, where the life insured is still the owner of the policy, the premiums cannot be deducted by the life insured from their annual taxes.

Using an RRSP/RRIF

Another way to leave money for a charity is to designate them as the beneficiary of an RRSP or RRIF, and then buy an insurance policy equivalent to the value of the RRSP/RRIF. At the time of death, the charity will issue a tax receipt which will offset the tax burdens, and then the estate will receive the life insurance proceeds tax-free.

Wealth Replacement Insurance

This is a very interesting way to use existing assets and insurance to donate money, lower your tax bill, and accumulate more wealth overall. This is something I actually got from http://lsminsurance.ca/tips/general/charity-life-insurance . I will just copy and paste it:

This is a creative option which allows you to donate a large asset or lump sum of money to charity. In return, you receive a charitable credit for the donation which results in tax savings for the year the donation is made. You can then invest these tax savings in an insurance policy that potentially results in enough proceeds to replace the value of the gifted property.

Let's look at an example of the last method.

Mrs. Jones own a piece of land that originally cost her $100,000. It is now worth $300,000. She donates the land to charity and receives a donation receipt for $300,000, which will equate to tax savings of approximately $138,000 (assuming a 46% marginal tax rate).

Mrs. Jones incurs a taxable capital gain on the disposition of the land of $100,000 (50% of $300,000-$100,000) resulting in tax payable of $46,000. However, the net tax savings of $92,000 could be used to fund a life insurance policy on Mrs. Jones producing a potential tax free death benefit for her heirs in excess of her original donation.

Annuities

A charitable gift annuity allows someone to give a lump sum contribution to a charity, but still receive guaranteed periodic income in return (usually monthly). Generally, the older the person is at the time of donation, the higher the returns will be.

Using this strategy, keep in mind that the donations are irrevocable, which means, once they are given, they cannot be taken back and the control of those funds is no longer there.

A tax receipt will be issued for the amount the gift exceeds the total annuity payments made to the donor (calculated by Canada Revenue Agency's life expectancy tables). Also note, that most (or all) of the income that is received is tax-free.

Using the life insurance strategy can be used with either term or permanent life insurance policies, so it can be used for short term and long term plans. If this is something that interests you, please consult an advisor to get more information on all the details.

I hope you have learned something from this post, and if you have any questions, please do not hesitate to contact me.