Reducing uncertainty with SWPs

Many mutual funds and ETFs offer a convenient T-class series, which pay out a percentage of assets in the form of a regular distribution. Typically, clients choose from among a variety of distribution rates on a fund’s T-class versions, such as 4%, 6% or 8% annually. The distribution usually can be received monthly, quarterly or annually, depending on the product and the client’s preferences.

Alternatively, you can use any investment fund to create a similar income stream for a client through a custom-made SWP that entails regular redemption of fund units. This type of SWP offers the ability to choose the dollar or percentage amount to be withdrawn on a regular basis, depending on the client’s needs and fund performance, then adjust the withdrawals according to changing circumstances.

Potentially, your clients could have the best of both worlds with SWPs or T-class funds – a steady annual income from their funds, as well as growth on the assets that remain invested.

The chances for portfolio growth and protection from inflation are higher if a fund has an equities component, as equities historically have outperformed fixed-income securities such as bonds and guaranteed investment certificates. Without growth, even a relatively low inflation rate of 2% a year can eat away at purchasing power. For example, at 2% inflation compounded for 25 years, the purchasing power of $100,000 would drop by $39,000 to $61,000.

“T-class funds are a good way to convert the potential higher returns of equities into steady cash flow,” says Rudy Luukko, investment funds and personal finance editor at Morningstar Canada in Toronto

Whether you recommend a T-class fund or a SWP for a client, your clients must understand they could be drawing down the principal of the fund if there is a shortfall between the return earned by the fund relative to the cash being taken out by the client.

“With current low levels of returns in financial markets, clients need to realize that a high payout can erode their savings, and that becomes a financial planning decision,” says Luukko.

Balanced funds and multi-fund portfolios are good choices for T-class versions and SWPs because they offer growth potential but tend to be less volatile than pure equity funds. Making withdrawals from highly volatile funds in down years can be uncomfortable for clients, as withdrawals would compound the depletion of the assets. Small-cap and emerging-markets funds are at the more volatile end of the spectrum.

“Determining the appropriate level of risk and how much equities exposure is suitable for the client is important,” says Debbie Ammeter, vice president of advanced financial planning at Investors Group Inc. of Winnipeg. “But even retired clients should be looking at a diversified portfolio. Reviewing returns and withdrawals regularly also is important, as there is a fine line between having a client deplete assets too quickly or ending up with more than he or she needs.”

Typically, T-class funds pay a large portion of their distributions in the form of return of capital (ROC), which is not immediately taxable for the client. Instead, the adjusted cost base of the client’s fund units must be reduced by the value of ROC every year. Taxes are deferred until the T-class funds are sold, and the difference between the proceeds and the adjusted cost base is taxed as a capital gain.

With SWPs, fund units are sold each year to create cash flow, and this can trigger a taxable capital gain if the units have risen in value relative to their cost base.

“Different types of income have different tax consequences,” says Ammeter.

With T-class funds, the classification of a large portion of the cash flow as tax- deferred ROC is attractive to many retirees who are concerned about keeping their income low enough to avoid the clawback of old-age security benefits. However, your clients need to realize that ROC is, essentially, a return of their own money or unrealized capital gain. That is not the same thing as annual interest paid by a bond, which has no effect on the bond’s face value. Taxes are deferred on ROC only until the units are sold or the adjusted cost base falls to zero, whichever happens first.

Dan Hallett, vice president and principal with HighView Financial Group of Oakville, Ont., says there is a danger that clients will not realize how much of the yield on T-class funds is made of ROC and how much comes from dividends, interest or realized capital gains that increase the fund units’ value. Distributions could deplete the value of assets if the fund’s return is not appreciating at the same rate. Neither SWPs nor T-class funds are like an annuity or pension that is guaranteed for life, and the SWP and T-class plans should not be left on autopilot.

“Many clients would choose to draw down income at a more sustainable rate if they were actually selling units to create the same level of cash flow,” Hallett says. “There’s a psychological aspect to it.”

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