High School

You recently graduated from university, and your job search led you to Hillsdale Inc. Because you felt the company’s business was taking off, you accepted a job offer. On the first day on the job, while you are finishing your employment paperwork, Shane Shillingford, who works in finance, stops by to inform you about the company’s defined contribution (DC) pension plan.

A DC pension plan is a retirement plan offered by many companies. Such plans are tax-deferred savings vehicles, meaning that any deposits you make into the plan are deducted from your current pre-tax income, so no current taxes are paid on the money. For example, assume your salary will be $100,000 per year. If you contribute $6,000 to the DC pension plan, you will pay taxes on only $94,000 in income. There are also no taxes paid on any capital gains or income while you are invested in the plan, but you do pay taxes when you withdraw money at retirement. As is fairly common, the company also has a 5% match. This means that the company will match your contribution up to 5% of your salary, but you must contribute to get the match.

The DC pension plan has several options for investments, most of which are mutual funds. A mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fund’s assets. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee, paid to the fund manager. The management fee is compensation for the manager, who makes all of the investment decisions for the fund.

Hillsdale Inc. uses TD Canada Trust as its DC pension plan administrator. Here are the investment options offered for employees:

1. **Company Stock**: One option in the DC pension plan is stock in Hillsdale Inc. The company is currently privately held. However, when you interviewed with the owner, Kevin Cooper, he informed you the company stock was expected to go public in the next three to four years. Until then, a company stock price is simply set each year by the board of directors.

2. **TD Canadian Index Fund**: This mutual fund tracks the S&P/TSX Composite. Stocks in the fund are weighted exactly the same as the S&P/TSX Composite. This means the fund return is approximately the return on the S&P/TSX Composite, minus expenses. Because an index fund purchases assets based on the composition of the index it is following, the fund manager is not required to research stocks and make investment decisions. The result is that the fund expenses are usually low. The TD Canadian Index Fund charges expenses of 0.88% of assets per year.

3. **TD Canadian Small-Cap Equity Fund**: This fund primarily invests in small-capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10% of its assets in companies based outside Canada. This fund charges 2.53% in expenses.

4. **TD Canadian Blue Chip Equity Fund**: This fund invests primarily in large-capitalization stocks of companies based in Canada. The fund is managed by Margot Richie and has outperformed the market in six of the last eight years. The fund charges 2.34% in expenses.

5. **TD Canadian Bond Fund**: This fund invests in long-term corporate bonds issued by Canada-domiciled companies. The fund is restricted to investments in bonds with an investment-grade credit rating. This fund charges 1.11% in expenses.

6. **TD Canadian Money Market Fund**: This fund invests in short-term, high–credit quality debt instruments, which include Treasury bills. As such, the return on the money market fund is only slightly higher than the return on Treasury bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges 0.77% in expenses.

Questions:

1. What advantages do the mutual funds offer compared to the company stock?

2. Assume you decide you should invest at least part of your money in large-capitalization stocks of companies based in Canada. What are the advantages and disadvantages of choosing the TD Canadian Blue Chip Equity Fund compared to the TD Canadian Index Fund?

3. What portfolio allocation would you choose? Why? Explain your thinking carefully.

Answer :

Mutual funds offer diversification, professional management, and lower risk compared to company stock; The TD Canadian Blue Chip Equity Fund provides potential outperformance with higher expenses than the TD Canadian Index Fund and portfolio allocation should consider risk tolerance, goals, and time horizon, with a balanced approach across asset classes.

The advantages of mutual funds compared to company stock include diversification, professional management, and lower risk. Mutual funds pool money from multiple investors and invest in a diversified portfolio of assets, reducing the impact of individual stock performance. Professional fund managers make investment decisions, leveraging their expertise and research, which can potentially result in better returns. Moreover, investing in mutual funds spreads the risk across various securities, reducing the reliance on a single company's stock performance.

Choosing the TD Canadian Blue Chip Equity Fund offers the advantage of potential outperformance compared to the TD Canadian Index Fund. The TD Canadian Blue Chip Equity Fund is managed by Margot Richie, who has a track record of outperforming the market. This active management approach aims to generate higher returns than the passive approach of the TD Canadian Index Fund, which closely mirrors the performance of the S&P/TSX Composite. However, the TD Canadian Blue Chip Equity Fund comes with higher expenses (2.34% compared to 0.88% for the TD Canadian Index Fund), which can eat into the overall returns.

The choice of portfolio allocation depends on various factors, including risk tolerance, investment goals, and time horizon. A balanced approach would be to allocate funds across different asset classes to mitigate risk and potentially enhance returns. For example, a diversified allocation could include a mix of equity funds like the TD Canadian Blue Chip Equity Fund for potential growth and stability, along with fixed-income options like the TD Canadian Bond Fund or TD Canadian Money Market Fund for income and capital preservation. The specific allocation should be based on the individual's risk appetite, financial objectives, and market conditions, considering a long-term investment horizon to ride out short-term market fluctuations.

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