[March 2007]

The search for income is like a treasure hunt for many advisors and their clients, and some are finding hidden gold in systematic withdrawal plans. An SWP lets inves-tors receive income through regular redemptions of any mutual fund units they own.

“In the low-yield environment that we are in now, systematic withdrawal plans can be an attractive alternative for income,” says Mark Chow, senior analyst with Morningstar Canada in Toronto.

“It’s difficult for retirees to live on the 4% or so that bonds are paying in interest,” he says. “There’s not much else around unless people are willing to invest in equities, dividend-paying stocks or income trusts, either directly or through mutual funds, and take on a little more risk.”

Responding to the hunger for income, a growing list of companies — including Mackenzie Financial Corp., Fidelity Investments Canada Ltd., Franklin Templeton Investments Ltd., Dynamic Mutual Funds Ltd. and Guardian Group of Funds Ltd. , all based in Toronto — have introduced “T” versions of their funds or wrap portfolios that have a built-in SWP.

Such funds pay out a predetermined annual percentage of assets in the form of a regular monthly income stream.

The income is designed to be as tax-efficient as possible by including a large portion of “return of capital,” which is not immediately taxable. However, T funds are less flexible than regular SWPs, which allow investors, not the fund company, to determine how much to cash out.

Any mutual fund can be used to create a regular SWP, but equity and balanced funds, or multi-fund wrap portfolios, make the most sense because of their potential for superior long-term returns. They also derive a lower percentage of their returns from interest income, which is fully taxable in the hands of investors. Although a fund’s volatility probably will increase with a higher percentage of equity holdings, as long as the fund attains a long-term rate of return that exceeds the SWP withdrawal rate there will be no erosion of the original capital.

Depending on performance and how much is taken out each year, there could be significant growth in the assets that remain in the fund.

“With a regular SWP, investors can control how much they take out, and also have the flexibility to alter this amount depending on their needs and on fund performance,” says Jamie Golombek, vice president of tax and estate planning with Toronto-based AIM Funds Management Inc.

AIM’s Trimark Fund, which was introduced in 1981 and has had an average annual return of 14.8% since inception, traditionally has been an ideal candidate for a regular SWP. If an investor had put $100,000 in the fund at inception and since then had regularly withdrawn $10,000 a year, which is $833 a month, he or she would have withdrawn $250,000 over the 25 years and would still have about $1.2 million in the fund. Such compounded growth would give the investor lots of leeway to increase or decrease annual withdrawals as expenses vary with inflation.

Protection from inflation is a key advantage of an equity-based investment relative to guaranteed investment certificates, for example. Although inflation currently hovers at an annual rate of about 1.6% in Canada, it has been significantly higher and there is no guarantee it will not rise again. Even a relatively low inflation rate of 2% a year can have a significant impact on purchasing power.

“In today’s environment, investors need a component of growth in their portfolios,” says Dan Richards, president of Toronto-based consulting firm Strategic Imperatives Ltd. “A traditional conservative approach won’t get them where they need to go. Pick your poison. It’s a matter of what kind of risk you want to take, but putting together an income portfolio typically is a matter of balancing different things, and involves a lot of creativity.”

When investors move from the accumulation phase of life into the disbursement era — in which they are living off their assets — a withdrawal rate of around 4% walks a fine line between providing an income and leaving enough in the portfolio to withstand the negative effects of inflation and bear markets, says Warren Baldwin, regional vice president of T.E. Financial Consultants Ltd. in Toronto.

“A withdrawal rate of around 4% probably will avoid any problem of running out of money, even with today’s longer life spans,” says Baldwin.

@page_break@Investors with regular SWPs need to cash out units to provide their income, which typically results in capital gains and, therefore, capital gains taxes — providing the fund has increased in value since they bought in.

While capital gains are an efficient form of income, the T funds introduced by fund companies are designed to provide an even more tax-efficient stream of income, with a large portion of it in the form of return of capital.

Return of capital is not taxable in the year received, although the piper must eventually be paid. Taxes are deferred until the units are sold or the adjusted cost base falls to zero, whichever happens first. Return of capital is actually a return of the inves-tors’ own money, and is often derived from unrealized capital gains.

A portion of the monthly distribution in T funds may also come from dividends, interest or realized capital gains, and such types of income are taxable at their usual rates.

To calculate the adjusted cost base, investors must reduce the original cost base of their fund units by the amount of their annual distribution paid in the form of return of capital. The lower cost base has the effect of increasing the capital gains when the units are ultimately sold. To reap the tax advantages on the distributions in the year received, T units must be held outside a registered plan such as an RRIF or RRSP.

As an added bonus, return of capital is not considered income for the purposes of calculating old-age security benefits and other government benefits, potentially leaving retirees with more income.

Another benefit is that inves-tors can control the timing of when they cash out of the fund entirely. If investors hang on their T fund long enough for the adjusted cost base to fall to zero, any further return of capital will then be taxable as regular capital gains.

Fidelity has been a leader in introducing T funds, launching its first 17 T-SWP funds in 2002. They are versions of existing funds — including asset-allocation, balanced, income trust, equity and life-cycle funds — with monthly distributions amounting to 8% annually.

Following the strong positive response to the funds, last November Fidelity introduced a line of 5% T-SWPs, billed as offering “more opportunity for capital preservation, increased cash flow in the future and inflation protection.” Investors can switch between the 5% and 8% versions without triggering switching costs or taxes.

Analysts caution, however, that investors considering T funds should take a hard look at past performance to make sure it has been good enough to pay the intended distribution. If not, the manager may be forced to dip into principal to provide the distribution, or may have to lower the distribution rate. Most T funds reserve the right to move the distribution rate up or down if market conditions warrant.

“There is an issue of sustaina-bility with any fund that promises an annual payout,” says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “If the payout is 8%, for example, you would have to add that to any decline the fund may experience in a down year to arrive at a value for the units, and it can be difficult for a fund to dig itself out of a hole like that.” IE



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