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Managing Exchange Rate Risk

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Where do you see the exchange rate going? This is a common question amongst our client base, many of whom enjoy a cross border lifestyle.  In fact, as Americans living in Canada may have noticed, the exchange rate is right up there with hockey and the weather in Canada’s national conversation.

The trouble is, accurately predicting the exchange rate is exceedingly difficult over both short- and long-term periods.  Even amongst currency analysts, who are the experts in this field, there is usually no consensus, a lone exception possibly existing when the loonie is trading at extreme values (either above par, or at 60 cents on the dollar).

The loonie is not currently at either extreme, but it has been volatile.  It fell about 8% against the greenback in 2018, rose significantly in January 2019 and moved lower through March.  Why is it so volatile, and why is it inherently difficult to predict the direction of the exchange rate?  The rate is impacted by more than one factor, which may push it in opposite directions.  For instance, the loonie is sometimes described as a petro-currency, driven by the price of oil.  As the price of oil (which is priced in USD) increases, all else being equal, the Canadian dollar would also increase relative to the US dollar.

The loonie is also driven by the differential between US and Canadian interest rates.  If rates on Canadian bonds are higher than those available in the US, then investors from outside Canada will tend to invest more money in Canada.  To purchase these investments, they need to convert their money into Canadian currency, driving the demand for loonies upward. This raises the value of the loonie relative to the US greenback.

It’s certainly possible to have the price of oil and the interest rate differential between Canada and the US pushing the exchange rate in opposite directions.  In the situation where oil prices are declining yet Canadian interest rates are rising relative to the US, it’s an open question which factor will have more impact.

Aside from these types of macroeconomic currency catalysts, there’s a school of thought that looks at what the value of a currency “should” be, based on equalizing what money can buy in various countries.  This is known as Purchasing Power Parity.  On this basis, the Canadian dollar is undervalued and should be worth somewhat more than it is now.  Unfortunately, it can stay this way for years, and does not spend much time at parity.  As a result, this metric is interesting but not necessarily any more helpful than other foreign exchange predictions for long term planning.

Given the notion that experts and scholars cannot make accurate predictions, how can cross-border financial planning be undertaken, and investment portfolios designed, for clients with assets in both currencies domiciled on either side of the border?  Financial planning is, to some extent, the practice of making assumptions about the future in order to provide clients with a picture of how that future will unfold provided the assumptions are perfectly correct.  As a result, financial plans are best presented with the caveat that they need to be refined over time to accommodate revisions to the assumptions as conditions change.

Unfortunately, the foreign exchange rate over the client’s lifetime is not the only unknown variable to consider.  Future rates of inflation and taxes on both sides of the border, as well as returns on investments in the stock and bond markets, are critical inputs.  Since the actual future values for these variables are uncertain, risk management tactics are utilized in portfolio design to reduce these risks.  This is equally true when it comes to currency risk.

One important consideration in cross-border wealth management is hedging investment securities into the currency of the country where retirement income will ultimately be spent.  It is often argued, correctly, that currency fluctuations tend to even out over the long term, and there is a financial cost to hedging strategies.  However, over the short term, those fluctuations can have a significant impact on investment portfolios and the income they provide.  While this extra layer of volatility can be worrisome for clients at any stage of life, it becomes increasingly critical when it has a direct impact on the amount of retirement spending a client can do from one year to the next.  A cross-border wealth management firm like Cardinal Point will use a prudent hedging strategy to manage the costs and benefits appropriately.

In addition, where possible, migrating assets over time into the client’s expected currency of residence in retirement can make a lot of sense.  For example, Americans working in Canada who plan to move back to America in retirement may hold their RRSPs in US dollars. The result is the minimization of the currency impact they experience long term.  Reducing the variability of future returns based on  exchange rate risk brings a dimension of certainty into an uncertain future.

Finally, it’s important to pay attention to the costs of converting money from one currency to another.  These costs can be 2% or more of the amount of money being converted.  If there is an ongoing need for a certain currency, a bank account denominated in the currency can be used to meet this need.  It’s best to minimize the movement from one currency to another, which can occur when money is moved between bank accounts, or a credit card issued in one country is used outside that country.  Where the need for conversion exists, using a specialized service provider such as OFX can result in significant savings on the transaction.

The exchange rate between the US and Canadian dollar is a significant source of risk for many clients. For Americans living in Canada and Canadians living in America, working with a cross-border financial planning firm is a prudent way to manage this significant financial and emotional process.

Cross Border Retirement Income: Canada Pension Plans, Canadian Old Age Security, U.S. Social Security and the Windfall Elimination Provision

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Calling all eligible benefit holders of the Canada Pension Plan (CPP), Canadian Old Age Security (OAS) and U.S. Social Security (SS)…

Does your or your spouse’s story narrate a history of employment in both Canada and the U.S.? If so, you may have the privilege of drawing from SS, OAS and CPP. The confusion lies amidst the qualifications and how these benefits interact with one another given the Windfall Elimination Provision (WEP).

Let’s break it down…

Social Security (SS)
To qualify for retirement benefits under U.S. Social Security, you must have 40 credits of covered work.  Each credit represents a quarter (i.e. 3 months) of full-time employment.  Thus, generally speaking, you must have 10 years of full time employment in order to qualify for retirement benefits.

All monthly benefits are based on your Primary Insurance Amount (PIA), which is the amount you would receive if you retired at your full retirement age (FRA). The FRA is age 65 for people born before 1938, gradually increasing to age 67 for those born in 1960 and later. You can choose to take it as early as age 62, resulting in a 25% reduction in benefits. At a more granular level, the monthly PIA is reduced by 5/9ths of 1% for each of the first 36 months before your FRA. You can also choose to earn delayed retirement credits (DRCs) for any month from FRA up to age 70. DRCs increase the benefit for the retired worker but not the spouse (if utilizing the spousal benefit). If you were born in 1943 or later, you earn 8% DRCs for each full year (prorated for months) up to age 70 for a maximum increase of 32%.

Individuals have the opportunity to take a SS benefit on the greater of their own record or 50% of their spouse’s SS benefit.

Canadian Old Age Security (OAS)
The rules to qualify for full OAS benefits under the Canadian system are centered on residency in Canada beyond the age of 18, not employment history. A full benefit is received when an individual has accumulated a Canadian residence history of 40 years. The pension can commence as early as the month following one’s 65th birthday or be delayed as late as age 70. By deferring one’s OAS, the benefit increases by 0.6% per month/7.2% per year, which equals a 36% increase if OAS is deferred to age 70. Partial OAS benefits may be available in certain situations. Let’s review a few scenarios:

Let’s assume you’ve lived in Canada less than 40 years and you are currently residing in Canada. As long as you are 65 years or older, a legal resident of Canada or Canadian citizen, and have lived in Canada at least 10 years since the age of 18, you are eligible for a prorated OAS benefit.

To take it a step further, let’s assume the same scenario with a bit of a twist. Instead of currently residing in Canada, you are now living in the U.S. These circumstances dictate you must have resided in Canada for a minimum of 20 years since the age of 18 in order to receive a partial benefit.

If neither of these examples apply to you, there may still be an opportunity to collect on the benefit if the country in which you currently reside has a social security agreement with Canada.

One final item on OAS; if one were to reside in Canada at the time of receipt of the OAS benefit, the individual may be subject to the OAS clawback. This would be created when your income exceeds certain threshold levels. For the 2019 tax year, the OAS clawback kicks in when income exceeds, $77,580. On the other hand, if OAS payments are made to a physical resident of the U.S. – and not a Canadian physical or tax resident – the clawback provisions are eliminated, and the entire benefit is paid to the recipient. No OAS clawback would apply.

Canada Pension Plan (CPP)
Unlike Old Age Security, CPP is based upon your pension contributions through your employment record, subject to certain maximums. As long as you’ve made at least one contribution to the plan, you are entitled to receive a CPP benefit. This benefit is available at age 65, but one can opt for a reduced benefit as early as age 60 (reduced by 7.2% annually) or a delayed benefit as late as age 70 (increased by 8.4% annually). In addition, the CPP benefit is not subject to any clawbacks.

How then do these benefits tie in with the Windfall Elimination Provision (WEP)?

Understanding the Windfall Elimination Provision
Under Title II of the Social Security Act, the Windfall Elimination Provision was born. It authorized the Social Security Administration to reduce an individual’s Social Security benefit in the event the recipient was also receiving a foreign pension (e.g. CPP). To understand the “why” behind the WEP, it’s important to comprehend how the SS benefit is calculated, specifically the Primary Insurance Amount (PIA).

A worker’s PIA is based off their average monthly earnings separated into three amounts. These values are then multiplied utilizing three distinct factors. Here’s an example:

For a worker who turns 62 in 2018, the first $895 of average monthly earnings is multiplied by 90%, earnings between $895 and $5,397 by 32%, and the balance by 15%. The sum of these three amounts equals the PIA, which is then either increased or decreased depending on when a worker decides to draw SS. This is how the monthly payment is determined.

Social security was meant to replace part of an individual’s pre-retirement earnings. With the previous calculation in mind, one can conclude that workers with lower average monthly earnings have a higher percentage of their pre-retirement earnings replaced via Social Security than those with higher average monthly earnings. For example, a 62 year old worker with average earnings per month of $3,000 could receive a benefit at FRA of $1,479 (49 percent of their pre-retirement earnings), increased by cost of living adjustments. For a worker with $8,000 of average earnings per month, the benefit starting at FRA could be $2,636 (32 percent of their pre-retirement earnings) plus cost of living adjustments.

For those individuals whose primary job wasn’t covered by Social Security, yet had their benefits calculated as if they were a long term, low-wage worker, they would end up receiving a benefit that would cover a higher percentage of their earnings, plus a pension from a job for which they didn’t pay Social Security taxes. This is true for someone who spent time working for an employer in Canada, earning CPP credits.

Under the Windfall Elimination Provision (WEP) the calculation for a worker’s Social Security benefit needs to account for the CPP payment. The 90% factor on the first $895 of monthly average earnings (when estimating PIA), could be reduced depending on the number of years of U.S. earnings history. The WEP is eliminated once a worker has 30 or more years of substantial earnings in the U.S.

The U.S. Social Security Administration has an Online WEP Calculator that is available here.

Despite the current provisions of WEP, a U.S. Class Action lawsuit has been filed on behalf of Canadians who receive SS benefits and have been impacted by WEP.  The suit was recently filed in the State of Indiana against the SSA. The crux of the lawsuit is whether the application of WEP against individuals who also receive the same benefits in Canada is lawful.  The Plaintiffs in the Class Action are claiming that the application of WEP to U.S. benefit recipients is unlawful and presents a violation of the plain meaning of the U.S. Social Security Act, U.S. Social Security Act Regulations and the Social Security Agreement (1983-1984) between United States and Canada (the “Social Security Agreement”). The Plaintiffs are seeking retroactive payment of the amounts that have been deducted through the application of WEP and the ending of the application of WEP moving forward.  The claim has been certified but has yet to move forward at the trial court level.

In Summary: Although a worker’s Social Security is potentially reduced by CPP, the good news is that OAS does not factor into the WEP calculation. Whether the WEP impacts your Social Security depends on the uniqueness of your individual circumstances and the potential result of the Class Action Lawsuit. If you think you might be impacted by WEP, we recommend you have a cross border financial planner such as Cardinal Point analyze your situation.

 

 

 

Terry Ritchie in “Weak loonie, competition from U.S. home buyers work against Canadian snowbirds”

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In past years, with a strong Canadian dollar, Canadian Snowbirds were able to pick up investment properties or vacation homes in popular locations such as Arizona, California and Florida. With a softer Canadian dollar, snowbirds are finding some competition for these types of homes. Cardinal Point Capital Management’s Terry Ritchie discusses the current state of the U.S. real estate market for snowbirds in this Globe and Mail article.

Terry Ritchie in “Yes, you can buy your way into U.S. citizenship”

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For Canadians looking to move to the U.S. permanently, one increasingly popular option is the EB-5 Immigrant Investor Program. This program, created by Congress in 1990, is known as the “million dollar green card” and offers a green card and a path to citizenship for an investment of between $500,000 and $1 million USD. Conditions apply, though. You must invest in a new commercial business that creates at least 10 full time jobs, the U.S. must be your country of principle residence, and in many cases, you must live near the business you’ve invested in and take an active role in its management. You’ll also have the U.S. government digging around in your personal finances and spend a substantial amount on administrative and legal fees. Cardinal Point Capital Management’s Terry Richie discusses the advantages and disadvantages of the EB-5 program with the Globe and Mail in this article.

Cross Border Transition Planning – RESPs

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“How do I move my financial life to another country?” It’s a question we hear from many clients as they begin making a cross-border transition. When you are making the move to the U.S., you want to transition your finances smoothly and seamlessly while saving time, headaches, and every dollar you possibly can.

Much like financial planning, transition planning is a process and not a transaction or an end in itself. And like financial planning, the most effective transition planning hinges on a clear understanding of what you want to achieve in terms of lifestyle both now and in the future.

One of our key roles as cross-border financial planners is to learn where you are trying to go (your goals and objectives) and then design a detailed plan to test the viability of your goals/objectives and ultimately get you to your destination. After all, without a flight plan, how can you know which direction to go?

One important area that should be considered when making a move across the border is education planning.  As a family you may have started a savings plan for you or your children’s education.  Registered Education Savings Plans (RESPs) are a popular savings vehicle in Canada for this goal due to available government grants, bonds and tax savings.  How are these accounts treated when one or both of the parties involved becomes a U.S. resident for tax purposes?

Subscriber (Owner) – The tax-sheltered status of an RESP only applies to Canadian tax residents.   With a move to the United States, income and capital gains within the account will now be reportable and taxable on the subscriber’s U.S. return.

IRS Tax Reporting – RESP accounts require annual disclosure on the subscriber’s U.S. tax return by one of two methods. The first is a school of thought that these are foreign trusts that require reporting on IRS forms 3520 and 3520-A, with income reported annually. The second method is to report the income annually on an IRS Schedule D and include a statement in the return indicating that the account is treated as a taxable brokerage account instead of a foreign trust.  Additional reporting may be required for the investments within the account. If you have already moved to the U.S. and filed a tax return, check with your accounting professional before deciding which of these options to use or before making any changes to your reporting.

It is possible to change the subscriber on an account to someone who is not impacted by these reporting requirements, but other factors relating to the Beneficiary and your contributions also need to be considered.

When a Beneficiary becomes a non-resident of Canada, contributions to the RESP are no longer allowed and the beneficiary is no longer eligible for government incentives.  If Canadian residency is re-established in the future, contributions can resume, and grants will again be paid, but the period the beneficiary was a non-resident does not qualify for accumulated grants.

Educational Assistance Payments (EAPs) are based on enrollment in qualified post-secondary studies or a specified educational program and

are comprised of earnings and any government incentives (grants, bonds).  A beneficiary must be a resident of Canada in order to receive the government incentive portion as part of the EAP, however, a non-resident can receive income earned within the account. An EAP may also be paid up to six-months after ceasing enrollment.   Thus beneficiaries qualify, in part, whether they remain a resident of Canada or become a tax resident of the United States.  When an EAP is made, The RESP promoter will issue a tax slip to the beneficiary, and the beneficiary will claim this on their personal tax return for the year of receipt.

If the beneficiary has completed their education, it may be possible to replace the beneficiary with one who can use the EAP government payments or investment earnings; however, if this is not an option the subscriber may need to close the account.

When an RESP is closed, the subscriber’s contributions can be withdrawn tax-free.  All grants and bonds remaining within the account must be returned to the government.  However, earnings can only be withdrawn (known as an Accumulated Income Payment, or AIP) if the account has been open for 10 years, the beneficiaries are at least 21 and not attending post-secondary education, AND, here’s the glitch, the subscriber is a resident of Canada.

If the RESP must be closed and the conditions for an AIP are not met, the remaining earnings in the account will be paid to a designated educational institution in Canada of your choosing.

If you are contemplating a move to the U.S. and have an RESP that has been open for greater than 10 years and beneficiaries that are over age 21, there are other options that may be available while you are still a tax resident of Canada.

The decision whether to keep your RESP open or close the account is as unique as your personal circumstances.  The knowledge and expertise of a cross-border planning professional can help you to determine what solution will work best for both the subscriber and beneficiary of the plan.  Please reach out to Cardinal Point to discuss how we can help you to make the choice that makes the most sense for you.