“Portfolios” is an ongoing series that discusses various asset-allocation options. In this issue, Investment Executive speaks with Hugh Russell, financial planner at Assante Capital Management Ltd. in Hamilton, Ont. and Olivia Woo, investment counsellor at T.E. Investment Counsel Inc. in Calgary.



The scenario: a husband, 70, and wife, 65, have 70% of their $200,000 in investible assets in oil and gas income trusts and the remainder in other income trusts. They realize that with the expected changes to the taxation of income trusts in 2011, they may need to restructure their portfolio.

Currently, the portfolio generates pretax income of $20,000. They each have $30,000 in pretax income from corporate pension plans, of which the surviving spouse receives 60%, and full Canada Pension Plan benefits. Their marginal tax rate is 32%, resulting in combined annual income of $75,000. Their $400,000 home is mortgage-free.

Their income goal is $75,000 after taxes in today’s dollars, until age 95. They would also like to leave an estate to their two independent children that is equal to the value of their current assets in today’s dollars.

Medical and dental coverage comes with their pensions, but they don’t have any life, long-term care or critical illness insurance. They are concerned about the high costs of health care if either or both need home care or admittance to a nursing home.



The solutions: even in the absence of the change in taxation, both Russell and Woo recommend that the couple dramatically reduce the amount of income trusts in their portfolio because of the risk involved in so much exposure to one sector and one type of investment vehicle. Russell suggests that only 7.5% of the portfolio should be in income trusts, while Woo would prefer just 5% and strongly recommends the couple’s investment in income trusts doesn’t exceed 10%.

Woo foresees a problem with getting the couple to reduce their holdings in income trusts. The two may perceive income trusts as fixed income, because the trusts have been marketed as an alternative to guaranteed investment certificates. Thus, the two seniors may not realize how much risk they are taking on — and will need to be educated about the risk attached to various investments. Both Woo and Russell emphasize that income trusts should be treated as equity.

Both advisors would like to see the couple diversify their portfolio as soon as possible. How quickly this can be done depends on how much capital gains their investments have generated and how much of their portfolio is held in mutual funds.

Russell points out that if the couple has invested through front-end or low-load mutual funds, it’s an easy matter to switch to other mutual funds. But, in the case of funds bought on deferred sales commission, they couple could face redemption fees if they cash out of the funds. In many cases, however, investors are able to switch to other funds in the same fund family without triggering redemption fees.

The problem arises if changing mutual funds triggers large capital gains. In that case, it might make sense to make the changes over a few taxation years to spread out the tax liability.

If the portfolio is invested in individual income trusts, capital gains may be even more of an issue. In addition, there may be trusts in the portfolio whose values are at unreasonably low levels, in which case it may make sense to hold off selling those trusts for a year or so.

On the other hand, Woo notes, a lot of income trusts will probably have to cut distributions in the near future to invest in growth. So, the couple shouldn’t wait longer than necessary before selling.

Russell recommends keeping any real estate investment trusts, as long as they don’t collectively account for more than 7.5% of the portfolio. If there aren’t any, he would recommend buying some on a selective basis, as they are not affected by the proposed taxation changes.

Woo agrees that REITs are good income trusts to own but notes that they don’t perform as well in a rising interest rate environment. As a result, she suggests waiting until the prices of REITs appear to be bottoming before buying any. And that time may be approaching. Most REITs have been taking quite a beating lately, she notes, so they may present some good buying opportunities.

@page_break@The downside of the switch to a more diversified portfolio is that it will lower the couple’s average annual return. Both Russell and Woo think the two seniors should work with an average annual return assumption of 6%-8% after fees. Russell is assuming an inflation rate of 2%-3%, while Woo would go with a broader range of 2%-4%.

Russell recommends a 50/50 split between equities and fixed income because he feels preserving what the couple has at this stage in their lives is more important than increasing returns. Woo, however, suggests a more aggressive split of 60% equities and 40% fixed income. She believes the couple needs more growth than a 50/50 split would generate in order to achieve their goals, especially given that the returns on bonds in the near term will not be as stellar as they have been in the past 10 years or so.

Assuming an 8% return, then, the couple would have an annual after-tax income of about $72,000, on which both Russell and Woo suspect the couple could manage. A 6% return would give them annual after-tax income of about $69,000, which Russell feels is still sufficient, considering they have no debt. Woo agrees, saying that although their financial situation would be tight, the couple should be able to manage with some minor adjustments to their lifestyle.

If they don’t want to be squeezed for income, they could consider downsizing their home. Putting an additional $100,000 into their portfolio would yield them an extra $4,000-$5,500 a year after taxes.

Another option, says Woo, is to take out a reverse mortgage. That would allow them to continue to spend $75,000 a year. But if they do so, they would have to lower their goal for the estate they would like to leave their children.

All this assumes, however, that their income requirements don’t shoot up because of medical expenses. Long-term care insurance could be purchased to cover this uncertainty, but paying the premiums would require either lowering other expenditures, reducing the amount they draw to live on or taking the money out of capital.

Russell thinks they should consider taking out a policy for long-term care insurance but suggests that the children be asked to pay the premiums because the children are the ones who will ultimately benefit. Without such insurance, the children’s inheritance could disappear. There’s also the risk that the kids will have to pay the medical costs of their parents’ care if the couple runs out of money.

It’s not always easy to persuade clients’ children that it is in their best interests to purchase life, critical illness or long-term care insurance for their parents even if that will maximize their inheritance. But, says Russell, if it can be done, it’s a win/win situation for everyone.

Woo agrees that this is a good option — if the children can afford the premiums.

BUY-AND-HOLD STRATEGY

Russell also suggests that the couple work with an accountant who could estimate at yearend what their annual tax bill would be, thereby allowing time to ensure that the cash is available on April 30. This would go into a transaction account.

Russell and Woo both recommend a buy-and-hold strategy. Both say fees would be low at 1% or less.

Russell would put 50% of the portfolio into investment-grade bonds. This could be a single bond or a ladder, depending on what is available. A ladder of five bonds going out three to 10 years would be ideal, Russell says. He would look for some monthly-coupon bonds as well as bonds with the usual semi-annual interest payments.

For the rest of the portfolio, Russell recommends putting 15% into Canadian equity mutual funds, 15% into global equity funds, 12.5% into three individual bank stocks and 7.5% into REITs.

Woo would put 35% into an investment-grade bond ladder going out no more than 10 years and 5% into preferred shares that benefit from the dividend tax credit. She also suggests allocating 25% to Canadian equities, 20% to international equities and 15% to U.S. equities. The equities would be invested in a mix of exchange-traded funds and low-cost mutual funds.

Because the goal is to generate cash flow from the portfolio, Woo says, the couple should look for equity funds that are geared toward dividend-paying stocks. There are many dividend- or income-oriented funds in the Canadian markets and globally. She notes that global companies, on average, have higher dividend yields but they don’t qualify for the dividend tax credit.

Russell believes 15% in foreign equities will provide sufficient geographical diversification. He recommends putting all the foreign equity into global funds, which he feels is a safer strategy than placing a portion in U.S. funds separately. While there are some good buys south of the border, he feels there is also a lot of uncertainty.

On the Canadian equity side, Russell recommends bank stocks: they are conservative investments with a steady dividend yield that will support the clients’ income objectives. He suggests large-cap equity funds for the rest of the Canadian equity portion.

Neither recommends alternative investments. Woo doesn’t see any need for them in a well-diversified portfolio; in Russell’s view, they add to the risk in a portfolio.

Neither advisor thinks the asset allocation will need to be changed as the couple ages, although changes in their circumstances could dictate a revisit. If one of them gets sick, for example, a more conservative asset mix might be appropriate to ensure a steady flow of income, adds Woo.

On the other hand, if long-term care insurance is purchased, the clients might want to switch to a more growth-oriented portfolio when they are in their 80s in order to maximize the size of the estate they leave. IE