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How to Invest a Lump Sum of Money

How to Invest a Lump Sum of Money

Everything is something you decide to do, and there is nothing you have to do.

~ Denis Waitley

I recently received an email from a reader I’ll call Karen. Her husband received a large lump sum settlement from an accident in which his neck was broken. (He has regained 85% mobility.) They have 5 children, but have still managed to pay off their mortgage by living very frugally.

They have a proposal from one of the big Canadian banks that includes management fees of $4000 per year. After 10 years, that would amount to $40 000. Karen was wondering if these fees were excessive, and whether or not I had any opinions on their situation.

Some Background Information

Two of their children will start post-secondary education in September. Another will head to college in January. They would like to help them out with expenses and set up RESPs for their 2 younger children.

Karen and her husband are not risk takers. They have about $350 000 in an open GIC earning 1%. They would like to put some money in TFSAs, and save for retirement (about 10 years away). It doesn’t sound like they have much, if anything, in RRSPs as they have focused instead on paying off their mortgage.

My 2 Cents

Since I am wholly unqualified to give advice on this, maybe I should have called this section My One Cent. Either way, here is the general advice I offered:

  • Get a lot of different opinions.
  • Don’t buy into anything you don’t understand and ask as many questions as it takes.
  • Make sure the advisor understands that you are looking for safety over high returns – ie. fewer stocks.
  • Make sure the advisor knows your time frame.
  • Pay attention to fees – both management fees and those built in to the investment products themselves.

One factor that I didn’t mention, but occurs to me right now, is to be aware of the tax consequences of your choices.

Jim Yih’s 2 Cents

One of the great things I’m really enjoying about blogging so far is the number of really nice people you can meet online. Jim Yih is one of those, and he knows a lot more about this type of issue than I do. As such, I sent him an email asking for his thoughts on Karen’s situation. He could have sent a 3-line reply, but instead he took the time to provide tons of useful information. Maybe I should have called this section Jim Yih’s 20 Cents. 🙂

Jim agreed with me that Karen and her husband should get lots of different opinions (at least 2, but 3 or 4 is better) and that the fee structure and amount were extremely important. He also reminded us that fees for a portfolio with very few equities (stocks) should be much lower than those for a portfolio with more market risk. Fees can vary widely, even for very similar products and services.

Jim also offered lots of resources from his website on the following topics:

In terms of investment strategy and tools, Jim noted that if you go to different types of advisors, you will find a lot of different solutions to the same problem:

  • Stock Brokers: have a wide range of investment opportunities and solutions but they do not focus on planning.
  • Life Insurance Agents: usually sell segregated funds, but cannot sell individual stocks and securities.
  • Financial Advisors: quick to emphasize the merits of a plan, but in the end are really selling mutual funds and insurance products.
  • Fee Only Planner: Jim admits to being biased on this one, but he’s not the only person who would favour this option. (Don’t forget that fee only planners are different from fee based planners.)

Jim said that thinking about all of this made him consider writing a post on different types of advisors. Keep your eyes on his site (Wealth Web Gurus) for more details!

Your 2 Cents

Karen referred to herself as “quite financially illiterate“. I would take issue with that, since she and her husband have managed to pay off their mortgage and raise 5 children under some pretty difficult circumstances. They sound a lot better off than some of the financial advisors that I’ve heard about who leveraged themselves to the gills during the market boom and got clobbered in the crash. Having said all of that, it is worthwhile to note that she and her husband are not all that knowledgeable about investing.

I know that a lot of the people who read this blog are more qualified than I am to answer this type of question. If you have a moment, please offer your 2 cents to this discussion in order to help out a fellow reader.

Considering everything you know about Karen and her family, what are your thoughts?

Comments

  1. peter

    I think that they can do better than having to pay 4 thousand dollars a year in fees. They are not risk takers, therefore perhaps they should stick with GIC’s, some in RRSP’s and some outside RRSP’s. At any rate they should be able to get closer to 3 percent in a GIC, one that is taken out over a longer time. Also TSFA’s should be maxed out for both of them. They can have these in GIC’s as well. Then a high interest savings account is another thing to look at, as they would be able to keep their emergency fund in this type of account, which would be readily available if needed in a hurry. Then of course there is the business of helping the kids through college, keep this low risk as well. One more thing, don’t open one big GIC, rather ladder them in 3 to 5 year maturity dates, that way in case interest drops or goes up you will have a better chance at always having a few making good interest rates. Remember there should be no fees with any of these investment, if you use one of the big banks.

    I personally have used GIC’s over the years, as opposed to taking risk with my money, and it has worked out well for me. Not a millionaire, but have not lost anything over the years either, and made a modest amount, which I am satisfied with. All the best with whatever choices you make.

    • 2 Cents

      This sounds like a nice safe strategy. Thanks very much for your input!

  2. Pacific Alan

    The most important consideration is your statement “Karen and her husband are not risk takers.” That means that they should stick with the guaranteed returns of GICs; especially considering the extra-ordinary uncertainty of the stock markets lately.
    The $4,000/year for ‘management fees’ is a rip-off considering that all they need are laddered GICs. There should be no fee for investing in GICs. They could put 1/5 in a 1-year GIC, 1/5 in a 2-year GIC, etc. etc. and get a very safe place for their money for up to 5 years. I see that the latest interest rates available are approaching 4% with minimum $50,000 investment.
    Definately they should get several different quotes from banks and investment dealers. For the latest GIC rates they can look at fiscalagents.com. For a Savings Account, People’s Trust in Vancouver are always the highest daily rates. Always keep in mind the $100,000 maximum for the CDIC (Canadina Deposit Insuance Corporation) limit. The tax consideration are offset by the certainty of Guaranteed Investments – you can’t have it all!

  3. Pacific Alan

    Well, I forgot to add there are ways of increasing the CDIC $100,000 limit, since there is a couple or family involved, as is explained on this page:
    http://www.ally.ca/en/cdic.html

    • 2 Cents

      I’m seeing a “safety first” theme developing here and I have to say that the all-GIC route is definitely something to consider seriously (IMHO). Aside from the low cost advantage, there’s the safety factor. As you say, and as I have been writing since I began this blog, the current market environment is likely to remain unstable for quite some time.

      Thanks so much for taking the time to offer your opinion to Karen and her family. 🙂

  4. WealthWebGurus.com

    Fees are important and it is great that Karen is aware. (see my article on mutual fund fees – http://tinyurl.com/24bns3p) I have seen and talked to many people that have no clue as to what fees they are paying. Fees are typically in relationship to the size of portfolio. A $4000 annual fee on a $160,000 mutual fund portfolio is a 2.5% annual fee. But that same $4000 fee on a $400,000 discretionary account is only 1% per year in fees.

    I think the $350,000 is separate from the lump sum in question so the other question is whether the fee is based on the entire portfolio or just the amount in question.

    If the fee is charged direct, it also may be tax deductible. As you can see, there are a lot of issues at stake here when it comes to fees. In my opinion, the most important issue to assess is something called risk capacity as opposed to risk tolerance. In simply terms it is the difference between how much risk they need to take vs how much risk they want to take. They may be risk adverse but can they afford to only invest in 2% to 3%? How much risk do they need to take (http://tinyurl.com/2u7bdfq).

    Thanks for the kind words 2 cents!

    • 2 Cents

      Thanks again for sharing all of this great information Jim. I’m sure Karen and her family aren’t the only ones to benefit from it. I had no idea there were so many issues around fees alone, never mind trying to decide where to put your money.

  5. Belmont Thornton

    Nice and safe strategies discussed ,even more useful as it is said from a commoner’s perspective. Different take on financial advisors is really useful.

    • 2 Cents

      Thanks. I really appreciated Jim’s take on advisors as well.

  6. Don Juan

    For GICs, I found out that Credit Unions are giving higher rates than the Banks. All my GICs are returning between 3.6% to 5.5% annually. In addition the money is 100% protected compared to the CDIC maximum insurance of $100,000. FYI – go to http://www.scu.mb.ca and check it yourself.

    • 2 Cents

      I checked out the site and their rates are really fantastic. I’ve been looking for a place to put my sons’ RESP where I could earn a little interest for keeping it in cash. It’s currently earning nothing in my brokerage account. I’m going to investigate this some more. The credit union in my neck of the woods doesn’t even come close to the 2% savings account rate listed at SCU. Thanks for the information! 🙂

  7. bb

    GICs are just as risky (arguably more risky) than a 100% equity portfolio. Why? Because “risk” is defined as the opportunity to lose. And in the short-term, the opportunity to lose money is described by volatility. The volatility in the market makes it “risky” and therefore not a good place to put your money if you need it soon. BUT IN THE LONG TERM, the opportunity to lose money is purchasing power or inflation; it’s what your money can buy.

    Fifty years ago, you could buy a really nice home in Toronto for $27,000. Today, you can buy a decent car for the same amount. The dollar value is there, but what you can buy with it has changed dramatically.

    So if you insist on storing your money in a GIC, do it with the knowledge that after tax and inflation, you are “guaranteed” to lose money. While an equity portfolio may go up and may go down month to month; in the long term it will be THE ONLY PLACE YOUR MONEY IS SAFE.

    • 2 Cents

      Thanks for presenting the other side of the argument bb, although I must say that I couldn’t disagree more. I understand the potential of inflation to devalue cash, but if inflation does become an issue, interest rates will rise to compensate for that. If you are invested in equities, you not only risk significant capital losses, but your money is just as exposed to inflation. The principal invested will be devalued just as much. Further, stocks often react poorly to inflation expectations.

      In the near term, my guess (yes, it’s only a guess) is that deflation will be a bigger concern than inflation. I can see reasons for inflationary pressures down the road, but not now. The global debt problem makes this a deflationary environment.

      There is no way that anyone can guarantee a positive return in equities over any period of time. You could have bought the Nikkei 225 index of Japanese stocks at 38 000 in 1989. Today it trades at 9500. I’ll take my chances with GICs.

  8. GR

    This was good solid advice as dealing with a large lump sum of money is not to be taken lightly. The first step is correct in regards to looking at all the options that are available to the investor. However, before you hand over your money to someone else to manage you need to at least educate yourself on the basics of investing. No one has more interest in your money then yourself. You owe it to your financial well being to know where and how your money is being invested.

    http://trade4keeps.com/2010/05/06/markets-are-selling-off-what-are-you-going-to-do/

  9. JS

    I definitely agree with the start of BB’s response. The GICs that everyone else is praising are only guaranteed to lose money in the long run. Because inflation eats into your measly return, yet you still have to pay taxes on the amount you “earn” (even though you can buy less with it), you only lose money in the long run. As well, most people don’t realize that the standard inflation rate that the government, and everyone else, talks about, is comprised of a basket of goods that generally does NOT include food or energy. (It might just be gas/oil that it doesn’t count, not all energy types – this part I’m not sure on.) So, if the cost of feeding your family, driving your car, and heating your house has gone up in the last years, add that to the cost of inflation, and then look at how your GICs rate compared to that.

    However, I disagree with BB’s take on stocks being the main thing that’ll go up over time. For some reason, people are forgetting the kind of investment that the vast majority of the world’s millionaires have either made or hold their fortunes in, and it’s also the form that Karen has probably experienced some success in: real estate. Now, I’m not suggesting that Karen just go out and buy any old property, as that would be remarkably silly. I don’t know where Karen lives, so I don’t know her market. So, she needs to get educated about it, first. Most places in Canada should do ok in it now, but if she’s in BC in general, or Vancouver in particular, it will be riskier. A great tool to determine if the real estate market is overheated is called the Housing Affordability Index, put out roughly quarterly by RBC. It compares how much the average wage and the average house price. Too often, people focus on just how much the house costs, but don’t look at the income. If most people in the area make $100 000, then a $400 000 house isn’t that expensive. However, if most make $25 000, then a $400 000 house is extremely expensive. As a general rule of thumb, if the percentage is over 40%, you’re entering dangerous territory. The index can be found here http://www.rbc.com/economics/market/pdf/house.pdf

    So, there are about 5 main ways that they can invest in real estate, either directly or indirectly. Indirectly, they can invest in a REIT, which is basically like a mutual fund of properties, as opposed to a mutual fund of stocks and such. I know very little about this type, so I can’t really comment on it except to say that if they go this route, they really have to due their due diligence.

    The other indirect way is to invest in 2nd mortgages. With these, they should be able to get at least 8% ROI per year, and often still 10-12%. If they go this route, then the property they’re holding the mortgage on should not have a LTV (Loan to Value) ratio of higher than 90%. (Translation….someone has a property worth
    $100 000, for simplicity’s sake. They have a regular first mortgage with a bank for 75%, or $75 000. Karen could register a mortgage for 15%, or $15 000 on the property, to free up some cash for the owner of the property. The owner would still have $10 000, or 10% equity in the property, as a safeguard.) In this situation, Karen is acting like a bank, and the owner would be sending her a check every month. Karen is NOT the owner of the property – she is solely a lender. Second mortgages can also be held in an RRSP, with all of those tax benefits, but most people don’t know about them as the banks want you to put your money in their mutual funds or in their GICs, and they don’t get any money if you invest in property like this. This link here http://www.misterrrsp.com/index.php?function=viewcategory&categoryid=12 is a good place to start looking into this.

    If they want to actively, directly invest in RE (real estate), they could also research a town, learn how to invest, and then buy a property. This is the best informational group I know of that teaches how to do so. http://www.reincanada.com/ and http://myreinspace.com/ They also have numerous books out, the prime one being Real Estate Investing in Canada. (And the author, Don R. Campbell, is a Canadian, and invests in Canada, and gives all the proceeds of his series of books to Habitat for Humanity – he makes his money from real estate and not from selling his books.)

    Fourthly, they could also JV (Joint Venture) with another, more seasoned, educated, and sophisticated real estate partner. What often happens is that one person provides the money, and the other provides the time, work, experience, etc., and handles all the headaches, as there are headaches involved with real estate investing, of course. In this situation, they would have to do a lot of due diligence on their partner, as they wouldn’t just want to give their money to just anyone. They’ll want to look at how long the person has been investing, how many properties they have, are they an expert in one particular area (or do they have 10 properties in 10 different provinces), how many JVs they’ve done, what return their JVs have made, get references from the JVs, check out the person’s credit rating, etc. (Myreinspace, above, can be a good source of partners, too.)

    However, the fifth option is the one that I think they’ll like the most. It lets them get into the market, but in a safer way. It’ll also help with their kids’ education, both in school and in life lessons. And that is to buy each kid a house at their university or college. The kids will rent out their rooms, bringing in enough money to more than cover their housing costs, so they will have some other money as well to cover extra schooling costs. And, the kids will have to learn some responsibility, as well.

    Now, as direct family members will be living there, they should be able to only put 5% down, and a mortgage for 95%. However, Karen probably won’t want to do that. Because of their aversion to risk, they’ll want to put a lot more down….25%, 30%, or possibly even 50%. As we all know, no market goes up in a straight line – there’s always some dips in it here and there. Having this buffer of 25 to 50% will cover that, especially as there’ll be enough money coming in from renting out rooms. That positive cashflow will enable them to ride out the rough spots. Even if the market stays completely flat for 4 years, they’ll still be making more money using this technique than they would investing in GICs, due to the constant cashflow and the mortgage paydown.

    Now, depending on where the kids go to school, there’s a very good chance that the market will go up in the next 4 years. On average, over the last 40ish years, the markets have gone up about 5% a year. But let’s be conservative, and say that it only goes up 3% a year. If they put 25% down, they’re not making 3% on their money, but rather 12% , due to the power of leverage. If they want to be really conservative, and put 50% down, then they’ll be making 6%. On top of that 12%, or 6%, (depending on the amount they put down), they’ll also be making a couple percent on the monthly cashflow, and another couple percent on paying down the mortgage. So, it’s not really 12 or 6 %, but rather 15ish or 9ish%. To my mind, even the very conservative 50% down, 9ish% return is lightyears ahead of the 1% that they’re currently earning.

    So, that’s what I think they should do. This last option lets them be as conservative as they want to be, while still making returns that are incredibly higher than they’re currently making. It’ll help their children go through school, and it’ll help teach their children some of what it means to be an adult while still providing them with some spending money.

    However, before jumping into this, they should definitely do some research. They don’t want to lose their money because they bought the first property, stock, or GIC that they see mentioned. They should take a few months, and just educate themselves about financial matters, and see what will work best for them.

    All the best!

    • 2 Cents

      Wow. Thanks for taking the time to provide so much detail JS. I should have asked you to write a guest post on real estate investing! The 5th option is indeed interesting. I’ve heard of that strategy before, but am by no means an expert on it. I learned a lot from your comment. Thanks for sharing your ideas! 🙂

      • JS

        My pleasure. I’m just glad I can help, especially as these other options are things that most people just don’t know enough about. I’d say that this probably comes from the fact that most people’s financial education comes from the banks’ salesmen (although the banks prefer the term “advisors”, for obvious reasons), and of course the banks don’t make any money off of these other options, so why publicize them?

        I probably should have mentioned that I am a member of REIN, (I gave 2 of their links), but I get absolutely no financial compensation for referring them. I’ve just seen how much they’ve helped me, other family members, and tons of other people, so I like to mention them to other people that need help.

        And, if Karen wants to contact me directly, feel free to send my email to her, privately of course. Have her title her email something like “Response to RE blog”, as that’s my spam-friendly email, and I wouldn’t want to mistakenly delete her email. And yes, I could easily be persuaded to guest-blog, if you actually do want one. I’ve been meaning to get into blogging myself, so this would be a good start. I am still learning about RE investing, of course, as it’s a huge field, but I’m more than happy to share what I know.

        Have a good one!

        • 2 Cents

          Again – thank you. I’d be happy to pass your email address along if Karen’s interested.

  10. Elli D.

    This should be solved in a series of eye-to-eye meetings with several experienced financial planners, not on in commentaries. Since they are risk-aware, the first rule should be: diversify. Given the monetary madness which has been happenning during recent years, I wouldn’t bet there won’t be a solid inflation of >5% for some years, so they should have this in mind too.

    • 2 Cents

      True. This forum is not the place to make final decisions, but to get an idea of what some of those possible decisions might be. Thanks for weighing in here!

  11. Ryan Martin

    I am in a similar situation, but it is my mother-in-law who is receiving an inheritance and isn’t sure what to do with the money. She has a mortgage so my first thought was to tell her to put the money there. Great additional food-for-thought in the comments! I also advised my mother-in-law to see an advisor, primarily because she doesn’t know where she is (financially) relative to others her age; an advisor will give her the good or bad news. It is good to know where you stand (in relation to your age, goals, etc), because you will have a better understanding whether your investment decision is too risky, too conservative, or just right for you.

    /my one cent.

    • 2 Cents

      Thanks for contributing your penny to the conversation Ryan. I think you’re right on the age thing. Your time horizon can make all the difference in the world as to where you want to put your money.

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