Cardinal Point Wealth Management

Your Cross-Border Financial Advisor

Contact Us | Client Login

Hedging Currency in your Portfolio

By

Portfolio management requires many decisions. One decision that many investors don’t give much thought to is how much of their financial net worth should be in their “home” currency. For example, if you’re living a cross border lifestyle, or have assets in two or more countries, how should you manage the different currencies you have in your portfolio? At Cardinal Point, we think about this a lot. The portfolios we manage are internationally diversified, and many of our clients invest in, and spend money in, more than one country.

When buying foreign stocks and bonds, you are really making two investment decisions. First, you are deciding to make the investment. Second, you are deciding to buy the currency. Or you can make the investment but “hedge” the currency. If you like the company but not the currency, then a professional manager would buy the company but hedge the currency risk. Hedging can be done in several ways though the concept is always the same. The end goal is to immunize the currency movement so that you are only exposed to the movement of the investment and not that of the currency as well.

All investment managers investing outside their “home” country are faced with currency hedging decisions. Cardinal Point is unique because we invest from two different countries and have clients that live and work in both. Not only do we have to make the currency hedging decision as it relates to the foreign content in portfolios, but we also have to consider how our client’s capital will be able to maximize returns and minimize risk when they may need retirement income in the other currency.

In order to explain how Cardinal Point approaches currency hedging from our unique vantage of serving investors in the U.S. and Canada, we will start with the basics that all portfolio managers should consider when investing in foreign stocks and bonds.

A Short History of Currency Hedging in Portfolios
When international investing first started, only very sophisticated investors like huge pension funds could hedge currency. The costs of hedging were too high and the types of products that allowed for it were underdeveloped. Currency hedging became more prevalent in the 1970s with the development of publicly available options and futures. In the early 1990s, some believed that you shouldn’t hedge your stocks because not doing so resulted in greater diversification.

One of the classic studies that was done in this area was Froot 19931. Kenneth Froot did research on portfolios and found that hedging the currency of a foreign stock portfolio did not decrease the variability as was previously believed. In fact, a stock portfolio that left the currency “un-hedged” had lower volatility.

This led to the concept that currency volatility actually reduces the volatility in foreign stocks. The concept goes something like this.

  • The return path of the currency moves independently from the return path of the stock.
  • So, if you pair the time series of the return of the stock with the time series of the return on the currency, you will get a time series with lower volatility than the return of the stock by itself.

This is similar to the concept that investing in two stocks will be less volatile than one because there are some days when the stocks will move in opposite directions. For stocks, the currency exposure can act as a further diversifier. The volatility of a portfolio of two or more foreign stocks can actually be reduced if the currency is left “un-hedged” in the portfolio.

This relationship can vary over time and can also change depending on which currency is the “home” currency. For Canadian investors, holding un-hedged U.S. stock positions can benefit from the USD strength that often accompanies broad market sell offs. But in times of CAD strength, the currency hedge can boost returns. It is tough to know in advance if the hedge will help or hurt, so we look to minimize the uncertainty by partially hedging stocks depending on the goals for the portfolio.

For bonds, the standard theory is different. The volatility in fixed income is much lower than equities. In fixed income, the addition of currency exposure may add greater volatility. The actual direction or return of the currency in any given year may far exceed the return of the underlying fixed income asset (bond or bond fund). Therefore, it is generally recommended that you hedge out your currency exposure of your fixed income. It has been the case over long periods of time that currency volatility can both help and hinder your portfolio returns. The rationale for currency hedging fixed income is because the currency volatility can swamp the income returns. Fixed income is supposed to reduce portfolio volatility, so we should not have currency exposure in bonds.

Cardinal Point’s Philosophy on Currency Hedging in Portfolios
Because we have investors in both Canada and the U.S., we had to rethink the conventional wisdom about hedging to your “home” currency. Many of our clients have spending needs in both countries. We believe it is important to think about the future portfolio cash outflows when developing a hedging strategy.

Literature on currency management is surprisingly thin on whether to hedge or not based on future cash outflows from portfolios. The idea of tying investment decisions to future cash outflows is known as an Asset Liability Management (ALM). There is a whole body of literature about managing with an ALM framework for pension plans. But very little of that relates to hedging currency with the specific intent that the income you earn matches the currency of future cash outflows. All literature on hedging or not hedging looks at risk vs. return of the decision and does not relate to the currency of future cash outflows.

We talk to clients about currency needs as part of their investment policy statement and portfolio construction process. Where appropriate, we encourage clients to keep their portfolio denominated in a manner that balances their future income needs. If currency exchange is needed, we have resources to help them convert their currency at more competitive exchange rates. We do not receive any financial compensation from recommending currency exchange providers, and we have negotiated competitive currency exchange rates with custodians on behalf of clients.

We deploy some currency hedging in most portfolios. Most of the bond exposure is hedged back to the currency of the portfolio, and some of the stock exposure is typically hedged. Currency management is one of the many ways we provide additional value to our clients. By taking a systematic approach to currency management, we believe our clients are more likely to have successful investment outcomes.

1 Froot, Kenneth A., 1993, Currency hedging over long horizons, NBER Working Paper No. 4355.

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

By

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.

 

 

 

Don’t Settle: Choose wisely when selecting a cross-border wealth management firm

By

Your whole life you have done things correctly: worked hard, saved and prudently invested your money. Then one day, out of the blue, you receive a letter from your U.S. investment management firm saying they no longer want to work with you because you reside outside of the U.S. Worse yet, they give you 90 days to transfer out your account or risk having your holdings liquidated. Whether it is a taxable or tax-deferred investment account, a forced liquidation and closure of your account can have  severe tax consequences. Furthermore, it can have a devastating effect on your long term retirement and savings goals. While the above scenario sounds  dire, it does not mean you should make a rushed decision and simply partner with the first firm that confirms they can take over the management of your account(s). Instead, take the opportunity to rethink what advisory firm would best serve your long-term interests as a non-resident. In other words, seek out a true cross-border wealth management firm that can not only deliver on the investment management piece but also provide ongoing value added cross-border financial, tax and estate planning solutions. The last thing you want to do is work with another firm that does not specialize in working with non-residents of the U.S., only to find out down the road you are once again being terminated from their platform.

So what characteristics should you be looking for in a true cross-border wealth management firm? The following checklist is a good starting point for selecting a company that’s right for you:

Cross-border platform – Make sure the firm and its advisors are legally licensed and registered in the jurisdiction you reside. Confirm they are not restricted on how your investment account can be managed based on your non-resident status.

Fiduciary vs. Suitability – It is important to confirm that the firm’s advisors operate under the fiduciary standard of care, which is a legal requirement that an advisor act in the best interest of his or her client. The fiduciary standard helps eliminate conflicts of interest. In contrast, the less stringent suitability standard adheres to a rule in which recommended investments must merely be “suitable” for but not necessarily in the best interest of a client. Most large investment brokerages, banks and wire houses operate under the suitability standard.

Fee-only – Finding an advisory firm that is fee-only and is not compensated by commissions, trading fees or financial products can eliminate conflict of interests between the advisor and the client.

Business Model – You cannot be all things to all people. Advisors who claim they work with four or five different categories of clients (retirees, small business owners, professionals, divorcees, expats, etc.) fall back into that “generalist” category. If you want to be an expert in what you do, focus on your niche. A financial firm with a business model of working exclusively with cross-border clients is typically better suited to handle expats or non-residents of the U.S.

Credentials, Experience and Education – Just because an advisor has a certain credential, doesn’t mean that they are an expert. That being said, when looking to partner with a cross-border financial advisory firm, make sure to review the bios of the individuals working at the company.  Have they been working with cross-border clientele for a long time? Do they have education or credentials in certain areas that focus on assisting cross-border clientele?

Cross-border Team – When building and preserving wealth, you’re only as strong as your weakest link. In other words, you may find a firm that can deliver on the investment management piece, but can they provide the ongoing cross-border or expat financial, tax and estate planning services you require? Look for a cross-border team that has dedicated portfolio managers who specialize in managing money for expats, and has international or cross-border tax experts and cross-border financial planners. All of these individuals have unique skill-sets that complement one another. Finding a firm that can provide comprehensive cross-border financial planning services in an integrated and coordinated fashion ensures no stone is left unturned when reviewing your situation.

Understanding of Tax – Understanding the tax rules and regulations of the jurisdiction in which you reside is extremely important when providing investment management services to non-residents. Further, if you are a U.S. citizen living abroad, you must also ensure the investment management strategy is tax managed based on U.S. tax rules. For example, the Passive Foreign Investment Companies (PFICs) rules will impact almost all foreign-traded mutual funds and ETFs. Ensuring you are not subjected to the punitive tax rules associated with holding a PFIC is critical. Make sure the firm you choose has a strong understanding of tax rules impacting non-residents and expats.

While no one wants to be faced with a surprise “move your investment account or else” deadline, don’t feel pressured to move your account to the first firm you speak to. Do your homework. Look to partner with a true cross-border wealth management firm that is positioned to provide long term value in addressing your unique and ongoing cross-border financial planning requirements.

Terry Ritchie featured in The Insurance & Investment Journal article, Managing Cross-Border Clients

By

From the Insurance & Investment Journal article:

Managing cross-border clients is a challenging area for advisors that requires thorough knowledge on how to handle life insurance, investments, taxes and pensions while respecting two countries’ rules and regulations.

The Insurance and Investment Journal spoke to U.S-Canada cross-border expert Terry Ritchie, a director at Cardinal Point Wealth Management, who’s specialized in the field for more than 25 years to find some answers. He says if you don’t have knowledge or experience it is very easy to mess things up for your client.

Read the article here

Moving to a Green Card Calls for Financial Planning

By

At Cardinal Point Wealth, we come across many situations where former Canadian residents have been working in the United States on an L-1 visa. This type of visa allows a U.S. employer to transfer a manager, executive or someone with “specialized knowledge” from an affiliated Canadian office to one of its U.S. offices.

To secure this visa, the U.S. employer must be doing business in the United States and have a current business relationship with the Canadian company or affiliate. Further, the employee must have worked for the Canadian company for at least one of the past three years.

For former Canadians, the initial term of the L-1 visa is two years, and it can be renewed for a total of seven years. Unlike many other types of U.S. work visas, the L-1 provides the opportunity for a spouse and dependents to work in the United States, through an L-2 visa.

Often, after years of employment and the acceptance of their new U.S. lifestyle, individuals consider pursuing a U.S. Green Card (GC). Unlike other issued U.S. work visas, an L-1 visa holder can apply for a GC.

A GC grants “lawful permanent residence status” for the worker and his or her family. The ability to live and work in the United States for as long as you want and for whomever you want—including yourself—can be compelling. After holding your GC for five years (three years if married to a U.S. citizen), you would be entitled to apply for U.S. citizenship.

The United States determines income-tax residency based on one of three factors: U.S. citizenship, holding a Green Card, or meeting what is called the substantial presence test—a calculation of the number of days one is physically present in the country over a three-year period.

Obviously, once you receive your GC you are considered a U.S. income-tax resident, subject to tax on your worldwide income and all the requisite tax compliance requirements.

After their first year of employment in the United States, L-1 holders would generally have been considered U.S. income-tax residents, subject to the filing of U.S. tax returns and related compliance requirements of foreign accounts. So for the vast majority of individuals going from an L-1 visa to a GC, their U.S. tax situation remains virtually the same.

In unique situations, L-1 holders who filed Form 1040NRs with U.S. treaty elections tie-breaking residency back to Canada may only be subject to U.S. tax on U.S.-sourced income—but that is a subject for another time. In this case, obtaining a GC could dramatically change an individual’s U.S. tax-filing situation.

If you are living and working in the United States on an L-1 visa, you should consider U.S. gift and estate tax planning needs. U.S. gift and estate-tax residency is often based on the concept of “domicile.” Domicile in the United States can best be defined as living in the country with no present intent of leaving. Living in the United States even briefly can often satisfy this requirement, so many believe that holding a GC or renewing one’s U.S. work visa is enough to establish domicile.

If domiciled in the United States, you would be subject to U.S. estate tax on your worldwide estate (including any remaining assets in Canada). That’s after the U.S. estate tax exemption–$5.43 million for 2015 and $5.45 million for 2016.

Gift tax would also be levied on lifetime transfers after the application of the annual exclusion of $14,000 for 2015 and 2016. Non-U.S. citizen spouses could be gifted $147,000 ($148,000 for 2016). So if you are considering obtaining a Green Card, you should update your estate plan to include the transfer of wealth at death to a non-citizen spouse (through the use of a qualified domestic trust, or QDOT). Assets that might remain in Canada would need to be addressed. If you ultimately become a U.S. citizen, then the role of a QDOT, and the transfer of assets during life between spouses beyond the annual exclusion, would not create adverse U.S. gift-tax results.

Many of our clients who pursue a GC choose to return to Canada on a part or full-time basis. In such a situation, it is important to be aware of the current U.S. expatriation tax laws that could be imposed when you leave the United States and return to Canada.

The expatriation tax provisions under Internal Revenue Code (IRC) sections 877 and 877A apply to U.S. citizens who have renounced their citizenship, as well as long-term residents (as defined in IRC 877(e)) who have ended their U.S.-resident status for federal tax purposes. Under these rules, a long-term resident would be defined as someone who held a GC in at least eight of the past 15 years. So does that mean eight full calendar years? No! Under specific circumstances, you could be considered a long-term resident for less than the eight-year period. Under the rules, you count the years of long-term residency by the “moment of time” that you had your GC during a calendar year. So in some situations, long-term-resident status could actually be achieved in six years!

If you did return to Canada and voluntarily abandoned your GC by filing USCIS Form I-407 (Record of Abandonment of Lawful Permanent Resident Status) or had it taken from by an immigration officer who believed you no longer intended to reside in the Unites States, you could find yourself subject to the expatriation tax laws. In such a case you would be required to file IRS Form 8854 (Initial and Annual Expatriation Statement), where you would be required to complete a worldwide balance sheet and income statement.

Further, two types of income tax, often referred to together as the “exit tax,” would be imposed on your worldwide assets. The first is a mark-to-market tax that would be imposed on the majority of your worldwide assets. You would be deemed to have disposed of these assets at fair market value on the date prior to your date of expatriation—or, in the case of a long-term resident, on the date prior to the abandonment of your Green Card.

After an exemption of $690,000 ($693,000 for 2016), you would be subject to capital gains tax on any gains subject to the mark-to-market calculation from Form 8854. Further, there would be an additional ordinary income tax imposed on any deferred compensation, pension plans, stock options, IRAs and other tax deferred vehicles, including registered assets in Canada.

From a financial-, income- and estate-planning perspective, the implications of the U.S. expatriation tax need to be strongly considered when one is considering returning to Canada after having held a GC for a period of time and being defined as a long-term resident.

The advisors at Cardinal Point Wealth understand the unique cross-border planning need of individuals who are considering living in the United States and returning to the Canada on a full- or part-time basis. Our clients’ financial plans are customized to meet each client’s specific goals and to help them make important decisions with confidence.