Beware 696-year TFSA investments Without equities, that’s how long a payoff may take Jonathan Chevreau, Financial Post Published: Friday, January 22, 2010

if you want to be paid a decent rate of interest, you must commit funds for a longer period. While the new tax-free savings accounts are proving to be popular, many Canadians are choosing only interest-bearing TFSA plans that pay so little that the accompanying tax savings are equally negligible. Negligible is an understatement. Consider that in 2009, the median one-year yield for Canadian money-market mutual funds was 0.3%, according to Morningstar Canada. That would mean you'd double your money in 232 years, says Morningstar investment funds editor Rudy Luukko. Or, if you calculate it based on the 0.1% six-month yield, you'd double your investment in 696 years. This is not quite as bad as in the United States, where the top 100 money-market funds have an average yield of 0.05%, which would take 1,000 years to double. Three-month federal paper yields 0.20% in Canada, versus 0.05% in the United States, says Dan Hallett, a director with HighView Asset Management Inc. "It would only take just south of 350 years to double your money invested at 0.2% annually, but I'd guess yields would creep up a few years before that time frame is up." Now consider the tax savings on these paltry yields. We'll be generous and juice the yield up to the 0.4% paid by Canada Savings bonds. A $5,000 TFSA investment in a CSB pays a grand total of $20 in interest after a year. Meanwhile, more adventuresome investors who put their TFSA contribution last March in stocks, equity funds or exchange-traded funds could easily be up 50% or more on the year. Perhaps because the "S" in TFSA stands for "savings," many TFSA newcomers don't realize they can also serve as supercharged tax-free investment accounts. A study by BMO Financial in 2009 found a whopping 94% of TFSA accounts are in savings accounts or term deposits. Even by mid-January 2010, TFSAs are still 90% in such accounts, says director of retirement strategies Tina Di Vito. People seem unaware they can invest their TFSA contributions in stocks, bonds and other financial assets, as well as in short-term deposits and GICs. In this respect, average investors are repeating the mistake made when they first opened up registered retirement savings plans through bank-offered GIC RRSPs that severely limited their investment options. In either case, it makes more sense to choose self-directed RRSPs or TFSAs that let you invest in stocks, bonds, mutual funds and ETFs, as well as interest-bearing securities. As of Jan. 1, Canadians could put a second $5,000 contribution into their TFSAs, assuming they put in their first $5,000 in 2009. If they did and later withdrew funds - perhaps to pay for a project to generate the soon-to-expire Home Renovation Tax Credit - they can repay that withdrawal back into their TFSA now that we're in the new year. So, for example, if you put in $5,000 early in 2009, then withdrew $3,000 in August, now that it is a new calendar year you can contribute $8,000: $3,000 to replace what you withdrew and $5,000 more in a "new contribution." The question remains how to invest it. Most financial advisors make emergency funds a priority, so it's logical that families with few financial resources might keep at least some of their TFSA in short-term, liquid, interest-bearing vehicles, such as high-interest savings accounts, money-market funds or GICs. The problem is the gap between short-term and long-term interest rates - the yield curve - has seldom been greater. So, if you want to be paid a decent rate of interest, you must commit the funds for a longer period. Cashable one-year GICs are one possibility. You lose some yield for the privilege of being able to cash out. A similar dynamic exists between cashable CSBs and locked-in Canada premium bonds. Other alternatives include strip bonds and bond ETFs, which may pay more, but can be cashed out if necessary, possibly sustaining a loss. The threat of an imminent rise in interest rates is why some investors are buying high-yielding dividend paying stocks, income trusts or preferred shares. These can be sold when you want but, as with bond ETFs, there's no guarantee you won't experience a short-term loss. Since TFSAs are extremely versatile, so should the investments you want to hold in them. Limiting them to interest-bearing investments when rates are so low is unwise. So switch to a self-directed TFSA: It can still own interest-bearing vehicles, but you'll have the best of all worlds. Unless, of course, you're content to double your money every few centuries.