Thursday, November 02, 2006

Too many eggs in the income trust basket

Investors are understandably upset with the Conservative government's proposed tax on income trust distributions. Share prices for income trusts declined about 12% yesterday. A change in government policy, however, is one of the many risks of investing in the stock market.

That is why financial advisers routinely recommend a well-diversified portfolio with holdings across asset classes. Holding all your eggs in the income-trust basket is simply asking for trouble. Consequently, it is hard to feel sorry for people like this guy:

Richard Milne, 74, who has invested most of his family’s savings in income trusts, estimated his losses following Tuesday’s tax decision at $50,000, although he says he hopes for some rebound. "They reneged on their promise," he said. "That really upsets me."

With any policy change, it is inevitable that some people will benefit and some people will get hurt. But this guy has clearly ignored the basic tenets of portfolio diversification: don’t put all your eggs in one basket. Rather than blaming the government, people should be taking it up with their financial advisor since it was common knowledge that something would have to give, particularly once BCE announced its intention to convert to the income trust structure.

In my view, Flaherty's decision on income trusts was a bold and brilliant move. Basically, it levels the playing field between corporations and income trusts, without raising the overall tax burden. At the same time, Canadian taxpayers will no longer be subsidizing foreign investors in Canadian income trusts.

Unlike Ralph Goodale, the previous Liberal Finance Minister, Flaherty acted quickly and decisively on this issue. Canada now has a tax policy that will require CEOs to focus on creating shareholder value the traditional way—by succeeding in the marketplace—rather than through financial and tax legerdemain. For seniors and other income trust investors, the damage is smartly mitigated by a phase-in period for existing trusts and income-splitting measures for pensioners.

Still, those investors affected by the change need to realize that their cash flows from income trust investments will not change very much if they were already being taxed at the personal level. While the decline in income trust share prices will hurt when it comes time to draw upon one's capital in late-retirement years, effective yields have now gone up (since the shares are less attractive to non-taxable and foreign investors and prices have gone down), which is good for those making new investments in existing income trusts.

The fallout from this decision illustrates one of the pitfalls of DIY investing. Too many investors, regrettably many of them seniors, do not seem to be cognisant of the investment risks of their portfolios. Yet they manage portfolios worth hundreds of thousands of dollars or more by themselves. While the yields on income trusts may seem attractive, there is a reason for it – they are risky investments, not GICs. Putting all your money in the income trust basket is not a very prudent approach to take in managing one's retirement savings. Any responsible financial advisor will tell you that. The government may make a convenient scapegoat for your incompetence, but ultimately, if you got hurt, you have only yourself to blame.