Source: The Canadian Press

As RRSP buying season reaches its peak, investors in Canada’s largest province are abandoning labour-sponsored funds as the tax advantages have begun to lose their lustre.

The Ontario government’s decision in 2005 to begin phasing out tax credits beginning in the 2010 tax year is having a chilling effect on these investments.

“It’s a lot less popular than it ever was and I rarely see any advertisements during RRSP season, let alone the rest of the year, which kind of tells that the industry is really dying here,” says Dan Hallett, director of asset management for HighView Financial Group.

The popularity of labour funds has been driven by heavy tax credit inducements. The federal and Ontario governments each reduced their tax credit in the late 1990s to 15%.

Ontario cut its rate to 10% for the 2010 tax year. It will be reduced to five per cent for 2011 before being eliminated entirely in 2012.

“The labour fund industry has been on crutches for a long time,” Hallett added.

Many of the 125 funds that existed across Canada in 2005 (67 in Ontario) subsequently merged and many have frozen redemptions.

Governments originally granted the tax credits to raise venture capital for small companies that had trouble tapping into conventional financing to grow. But as these funds became more popular, gimmicky products surfaced as new entrants merely focused on raising money, he said.

Financial advisors routinely caution against buying any investment purely for a tax credit. Instead, the gains must be factored into the entire investment opportunity.

Hallett said these funds are most attractive to higher income earners and those with long investment time horizons because of the long locked-in period. He urges people to limit their exposure to less than 10% of total holdings because of the risk from investing in small private companies and the challenges of extracting your money.

Labour fund critics say the tax credits mask the poor quality of the investment returns.

“It’s totally irrational to invest if you don’t have tax breaks,” says Doug Cumming, a finance professor at York University’s Schulich School of Business.

A fervent critic of such venture capital funds, Cumming said they generate anemic returns, have excessive management fees and are a drain on government revenues.

The federal and provincial governments lost about $3.6 billion in foregone revenues between 1991 and 2003.

Cumming said the tax-subsidized funds crowd out private investment. Better ways for governments to stimulate venture capital funding include reducing capital gains tax rates and more generous treatment for employee stock options, he added.

While the funds have come under attack in Ontario, they remain popular in Quebec, which has Canada’s oldest and largest labour fund, affiliated with the province’s largest union.

Working class citizens are lured by numerous advertisements to invest in the Solidarity Fund and the plea to help Quebec businesses and create jobs.

The Solidarity Fund invests in more than 2,000 companies, including small start-ups. But critics question the decision to financially support large companies like Bombardier, Transat and Transcontinental. It even partnered with the Molson family to purchase the Montreal Canadiens hockey team.

The fund’s structure has succeeded by using an army of volunteers who carry the message at work sites, encouraging employees to purchase up to $5,000 per year by enrolling in payroll deductions.

“Most of the investors are blue collar workers, not the rich,” says Mario Tremblay, vice-president public and corporate affairs.

The Solidarity Fund generated $600 million of investments last year and is on track to receive some $700 million in 2010.

Fondaction, a fund created in 1996 by the Confederation of National Trade Unions, has already achieved its maximum $150 million enrolment more than two weeks early.

The fund is more attractive because the province raised its tax credit to 25% to help the fund establish itself.

With more than $7 billion of net assets accumulated from 577,000 shareholders since being founded in 1983, the Solidarity Fund has developed a critical size, says Tremblay.

Unlike labour funds in other parts of Canada, Quebec’s fund has earned steady returns. Including the 30% tax credits, it has earned a compound annual return of 10.5% over seven years and 7.9% over 10 years.

That’s greater than the 4.1% average return generated by Canadian balanced mutual funds, he noted.

Canadians in provinces aside from Alberta and PEI can also buy labour funds. Provincial tax credits range between 15 and 25%.

Maximum annual investments range between $5,000 in Quebec and Saskatchewan, to $13,333 in British Columbia.

With the savings rate so low and the indebtedness of Quebecers so high, the province’s labour funds are a good way to encourage young workers to save for their retirement investing, Solidarity Fund officials say.

An internal 2008 study for the Solidarity Fund found that it was the first RRSP purchased by 36% of its investors. And 80% of those workers went on to purchase other savings products.