Consider the following: a retired couple, both aged 65, own a mortgage-free condominium and a cottage. They each get $30,000 pre-tax a year from indexed pensions, which is 60% of their preretirement income. They want to travel to places such as China and Russia while they are physically able and have money left to meet health costs should one or both become ill. They believe that with their pension income, Canada Pension Plan, old-age security and an additional $10,000 a year after taxes, they can do just that.

For how long can the couple generate that $10,000 a year, after taxes and after inflation, from their $200,000 portfolio?

Two advisors among those interviewed by Investment Executive say the couple could probably count on 30 or more years, but Mark Yamata, president of Toronto-based Guardian Capital Advisors LP, suggests they could run through the assets in 17 years.

The key in such a situation is capital preservation, Yamata says, given the potential health costs should either or both become ill. If the income generated by the portfolio is to provide a safety net, he suggests they not let the portfolio’s value drop below $50,000 in real terms. Instead, he says, they should lower their lifestyle expectations so that $6,000 a year would cover their costs. If they take out $10,000 a year, there’s a 90% probability that they would have only $50,000 left in 15 years. Although the couple would still have salable assets in the cottage and the condo, in the case of the latter, the price would need to yield enough to cover rent on another residence to justify the sale.

Thus, Yamata would recommend the couple place their holdings in a very conservative asset mix of 70% fixed-income and 30% equities invested in exchange-traded funds, which would yield an average annual return of 2.7% after taxes, inflation of 3% and fees.

Karen Bleasby, chief strategist for Toronto-based Mackenzie Financial Corp. ’s private-client business, says the $200,000 could be preserved indefinitely if it generated a 4.1% average annual return after taxes, inflation of 2.5% and fees. But since a 4.1% return is unlikely, she suggests a more reasonable average return of 2.8%-3.7% by investing 80% in equities and 20% in fixed-income (using, not surprisingly, Mackenzie capital-class mutual funds.)

Bleasby feels the portfolio can be 80% weighted in equities because she considers the pension assets — which would total about $425,000 — as part of the couple’s financial assets. She assumes they are invested in fixed-income; thus, 80% equities would represent only 26% of the asset mix for all financial assets.

The low end of Bleasby’s return range is not much different than Yamata’s 2.7%. That is because Guardian is assuming a 7.7% return on fixed-income before taxes and inflation (the average return on Canadian bonds over the past 10 years), while Bleasby is assuming 4%, the recent return on a 10-year Canada bond.

Bleasby thinks the 2.8% return would only halve the $200,000 portfolio in real terms over 20 years, while much more would be left if the return was 3.7%, at the top end of her range. Yamata’s more pessimistic conclusion is the result of the Monte Carlo analysis that Guardian uses, which involves thousands of simulations with different mixes of volatility and returns, resulting in the probabilities for certain outcomes.

Garth Bechtel, senior investment advisor at HSBC Securities (Canada) Inc. in Toronto, is much more optimistic. This is partly because he is assuming inflation of 2%, lower than Bleasby and Yamata, and a fixed-income return of about 4%. Combined with the use of some income trusts, he projects an annual real return of 4.5%-6%, which means the assets remain intact in real terms, although there may be some years in which capital has to be withdrawn.

Bechtel suggests the couple could rent out the cottage in years when the portfolio’s yield isn’t enough. If they find the portfolio isn’t achieving the necessary return or they need more income, they could sell the cottage and not take those holidays. They could also sell the condo and rent something more modest, or they could live at the cottage.

The asset allocation Bechtel recommends is 50% equities, 30% fixed-income and 20% cash. The equities would be 60% Canadian invested in a combination of three or four large-cap stocks, such as banks, life insurers, utilities and oil companies; a couple of income trusts that have high-quality earnings, as judged by a bond-rating agencies; and the TSX 60 exchange-trade fund. The foreign equities would be in ETFs.

@page_break@Bechtel’s expected return is enhanced by the inclusion of income trusts. Guardian might put some equity in income trusts — currently there’s only a real estate investment trust ETF, although Barclays Global Investors Canada Ltd. plans to launch a broad-based income trust ETF. Bleasby, however, doesn’t think income trusts are suitable assets for this couple, even though there would probably be some income trusts in the equity mutual funds.

In terms of the fees on the recommended investments, they range from 1.05% for Yamata to 1%-1.5% for Bechtel to 2.3%-2.5% for Bleasby. Yamata, who recommends ETFs for the equity portion of the portfolio, suggests the couple use Guardian’s ETFolios program, which includes rebalancing on an “as needed” basis — probably twice a year, in this case. This adds 80 basis points to the embedded 25-bps fee for the ETFs.

Bechtel recommends a fee-based account; at HSBC, those fees vary with the asset mix. Fees include 10 to 15 transactions a year — which are more than this couple would probably use. (A maturing bond is not a transaction.)

Clearly, inflation also matters. If inflation averages 3% a year, Bechtel’s 4.5%-6% net return shrinks to 3.5-5% and more capital would need to be withdrawn. Similarly, Bleasby’s 2.8%-3.7% net return would shrink to 2.3%-3.2%, eroding more capital.

All three recommend some foreign equities to provide geographical diversification to minimize downside risk. Yamata recommends 100% foreign equities, which Guardian’s Monte Carlo analysis suggests will result in the highest returns. Bleasby suggests 50% foreign equities and Bechtel suggests 40%. In both cases, the foreign equities would be divided 50/50 as U.S. and other international holdings.

Bleasby and Bechtel say the couple should also take advantage of the Canadian dividend tax credit, particularly if it is increased, as was proposed by the Liberals, pre-election. But, Yamata says, even though the dividend tax credit is beneficial to all investors, it benefits the highest taxed the most. In this case, the benefit of global investments, both in terms of lower risk and higher returns, should result in higher returns than having some or all of the equities in Canadian investments.

Besides using the dividend tax credit, Bleasby’s recommends capital-class mutual funds, which enhance their returns through tax efficiency by deferring capital gains as long as the investor remains within the capital-class family.

Both she and Yamata consider sector diversification to be important; as a result, the strategy is included in their solutions. The couple should choose mutual funds that are diversified by sector or ETFs, which have natural sector diversification because they are generally based on broad indices. Neither Bleasby nor Yamata recommend sector-specific funds for a portfolio of this size.

Bechtel, on the other hand, doesn’t feel sector diversification is critical in this case. There’s sector diversification in the foreign equities portion, which he suggests be invested in ETFs, but only some in the Canadian portion through the TSX 60 ETF.

Only Bleasby says style diversification is important. In this case, it would be easily achieved using the Mackenzie funds.

For fixed-income, Bleasby would use a mutual fund invested in short-term bonds to provide liquidity and safety, while Yamata suggests a broad-based bond ETF. Bechtel recommends Government of Canada bonds, as well as provincial bonds or corporate bonds rated A or better; these would be laddered over three to five years. Real-return bonds could be included if attractively priced. For the cash portion, Bechtel would use Canada Savings Bonds if attractively priced or the HSBC money market fund, which has a 15 bps-20 bps fee that would be waived for a fee-based account. For cash needed at a specific date, he would try to match assets with T-bills or banker’s acceptances that would mature at that time.

All three advisors agree the couple don’t have enough assets to justify the use of alternative investments, which can be risky. Nevertheless, Bechtel says, that if they have an expertise in stamps, coins, art or some other collectible, they could take $10,000, for instance, and invest it in that. The only caveat is that they have to be prepared to sell when funds are needed.

Rebalancing the portfolio is not an issue with Yamata’s ETFolios program solution. In the other two cases, the advisor and client would need to pay attention. The portfolio would need to be monitored closely and tweaking could be necessary.

If rebalancing is something the couple doesn’t want to worry about, Bleasby suggests Mackenzie Symmetry program, which automatically rebalances. The couple may not get the equity allocation they want, but they may accept slightly lower returns to avoid rebalancing. IE