A growing number of Canadians are reaching the age at which they are relying on their savings to provide some income, and systematic withdrawal plans are moving to the top of the list of strategies for doing so efficiently.

Essentially, SWPs allow investors to receive income through the regular redemption of mutual fund units. If the amount withdrawn is less than the growth of the fund, the fund can continue to expand and compound, allowing investors to have their cake and eat some of it as well. As most mutual funds fluctuate in value because of the unstable nature of their holdings, the key is that over the long term they perform at a rate that exceeds the withdrawal rate.

“A systematic withdrawal plan is essentially the opposite of a dollar-cost averaging strategy,” says Moshe Milevsky, associate professor of finance at York University in Toronto. “Instead of money going into funds on a regular basis, it is coming out. SWPs can be one of a handful of strategies that investors use to produce an income stream — but they will be exposed to the vagaries of financial markets.”

Any kind of mutual fund can be used to create a SWP, but equity and balanced funds make the most sense because of their ability to provide superior returns over the long term. A SWP can be designed to cash a predetermined percentage or fixed dollar amount of fund units, usually on a monthly or quarterly basis.

A handful of fund companies, including Mackenzie Financial Services Inc., IA Clarington Investments Inc. and Fidelity Investments Canada Ltd., all of Toronto, offer a twist on SWPs. They have funds designed to pay out a pre-set regular income, but in a more tax-efficient manner than ordinary SWPs, in which investors are simply cashing out the desired amount of fund units.

Mackenzie’s T-Series and Fidelity’s T-SWP funds, for example, have special structures that provide monthly distributions with a large component of “return of capital,” which is not taxable in the year it is received. As an added bonus, return of capital is not considered income for the purpose of calculating old-age security and other government benefits, and therefore offers retirees some protection from clawbacks.

Return of capital is actually a return of the investor’s own money, and is often derived from unrealized capital gains in the fund. A portion of the monthly distributions on the funds also comes from dividends, interest and realized capital gains, and such types of income are taxable at their usual rates.

Mackenzie offers the T-Series on 11 conservative balanced Mackenzie and Keystone funds. Each T-Series fund is structured to pay a monthly distribution of 8% a year based on the previous yearend’s net asset value.

Fidelity offers a T-SWP version of 17 of its funds, also with monthly cash flow of 8% a year. These include asset-allocation and balanced funds, an income-trust fund, equity funds and life-cycle funds. The life-cycle funds adjust their portfolios toward more conservative holdings as the funds edge closer to a pre-set maturity date.

Both fund companies stress the 8% return is not carved in stone, and could be adjusted by the firms.

With the return of capital payment, there is ultimately a day of reckoning as income tax is only deferred. The adjusted cost base of the each investor’s units is revised downward each year by the amount of distribution attributed to return of capital. When the remaining fund units are ultimately sold, the investor’s resulting capital gain or loss will be based on the difference between the adjusted cost base and the proceeds. The investor can control the timing, however, and it may be advantageous to sell at a point at which overall personal income is lower.

If investors hang on to their T funds long enough for the adjusted cost base to fall to zero, any further return of capital will then be taxable as regular capital gains.

“The T-Series funds are a nice alternative to GICs,” says Carol Bezaire, Mackenzie’s vice president of tax and estate planning. “The distribution payment is steady and offers the advantage of deferring taxes to a later date, when the investor may be in a lower bracket.”

IA Clarington has offered its tax-advantaged Canadian Income Fund since 1996, and has subsequently added six other funds that provide a regular monthly yield. Although Canadian Income Fund started its life with a monthly yield of 8¢ a unit, or 9.6% annually, its performance wasn’t strong enough to continue paying such distributions without cutting into the fund’s assets; in 2002 the monthly yield was reduced to 6¢ a unit.

@page_break@“One of the biggest misconceptions investors have about these funds is that the distribution rate equals the actual return,” says Eric Frape, vice president of product management at IA Clarington. “The two are completely independent of each other. Our goal is that the fund’s performance will at least equal if not exceed the payout, but there is no guarantee. If the fund doesn’t make the return, the investor may be faced with a smaller pool of capital at the end of the day.”

Dan Hallett, fund analyst and president of Windsor, Ont.-based Dan Hallett & Associates Inc., says high-payout funds should be used with caution, and there must be a sustainable withdrawal rate to avoid “the serious risk of running out of money prematurely.”

A look at a fund’s past performance can give a picture of its performance history, but ongoing performance requires monitoring if the investor is concerned about capital preservation.

Jamie Golombek, vice president of tax and estate planning at AIM Funds Management Inc. of Toronto, says although the return on capital portion of the return on the special funds is tax-deferred, the real advantage comes if the investor chooses to invest the tax savings.

“Usually, investors spend those tax savings every year, but meanwhile they are building up a future tax liability,” Golombek says. “At AIM Trimark, we still believe the regular SWPs are already extremely tax-efficient. Maximum efficiency is achieved with an equity fund that generates its return through capital gains and some dividends. A balanced fund has an interest income component, and the interest is subject to higher taxes.”

An investor who had put $100,000 into Trimark Fund at its inception in 1981, then withdrew $10,000 every year (equal to $833 every month) while reinvesting income and capital gains realized by the fund would have seen assets in the fund grow to $1.1 million. The fund has achieved an average annual return of 14% since inception. IE