With equities markets sagging, interest rates in the basement and pensions shrinking, many clients are looking for innovative ways to build diversified income streams in retirement.
Given that each financial product and strategy has its own advantages and disadvantages, the task for financial advisors is to help match the features of these products and strategies to clients’ personal circumstances.
“You will have to get a firm understanding,” says Scott Ward, financial advisor with Edward Jones in Etobicoke, Ont., “of how much retirement income [clients] will need; how much risk they should take to achieve their required cash flow; how much risk they are actually willing to take; and an estimate of how long they will need an income stream.”
A diversified income portfolio should have two main components, says Norman Raschkowan, executive vice president, investments, and chief North American investment strategist with Mackenzie Financial Corp. in Toronto.
One portion should be annuitized to provide a secure cash flow, with inflation protection, such as guaranteed minimum withdrawal benefit funds and indexed annuities. The second should incorporate traditional investments such as equities and bonds for growth and income, such as mutual funds.
Bonds, of course, are a mainstay in the portfolios of older clients, who should not be taking on high degrees of risk. But this category is changing. Traditionally, says Edward Jong, vice president and head of fixed-income with TriDelta Financial Partners Inc. in Toronto, “Govern-ment bonds have been a primary source of retirement income. But with five-year yields at about 1.5%, it is difficult to tell investors to hop into them.” As a result, he adds, “You would have to go down the credit spectrum and invest in vehicles like corporate bonds.”
Investment-grade corporate bonds currently yield about 4%, which is higher than government bonds, to compensate for their higher risk, says Jong. Clients willing to take on more risk can invest in lower-grade, high-yield bonds, which currently yield about 8%. These bonds, which behave like equities, are subject to greater market volatility and also pose the risk of default if their issuers cannot meet their payment obligations. (See story on page B8).
On the equities side, the shares of companies with strong records of paying dividends are increasingly popular as a healthy source of retirement income. Raschkowan says you should look for high-quality companies that have strong earnings growth potential, such as Canadian banks, whose shares currently are yielding between 4% and 5% and have relatively low risk. With this option, the uncertainty is that dividend-paying stocks are subject to market volatility and can appreciate or depreciate in value.
An alternative among equities is preferred shares, which have a fixed par value and pay out a fixed dividend, says Jong. Unlike common stocks, the price of preferred shares moves in a manner similar to that of bonds. When interest rates rise, their prices fall; and when rates fall, their prices rise.
A more secure or guaranteed income stream can be derived from insurance-based products such as annuities, GMWBs and guaranteed life withdrawal benefit funds (See story on page B12).
Annuities come in many forms, with the two most common being fixed- and variable-rate annuities. These provide regular income payments that may incorporate both interest and return of capital; these products are based on large, lump-sum initial investments. The payments can be either for life or for a specified period. “Fixed-rate annuities do not make a lot of sense in the current environment,” says Ward, “as clients can run out of money” because the growth for these products is tied to interest rates.
On the other hand, variable-rate annuities may invest in different vehicles, such as equities, which provide at least some capital growth potential.
Closely tied to traditional annuities are GMWBs and GLWBs, which are essentially hybrids of annuities and segregated funds. Both GMWBs and GLWBs offer a guaranteed income stream based on a certain percentage, usually 5% to 7%, of the client’s investment.
GMWBs and GLWBs differ in that GLWBs provide a lifetime income stream, usually at a lower rate than GMWBs, which pay out for a defined period, typically between 15 and 20 years. The good thing about GMWBs and GLWBs is that clients will get the guaranteed income stream, regardless of market performance.
The downside to these insurance-based products, says Rasch-kowan, is that they provide “a secure income stream at a higher cost.”
Adds Ward: “They do not have liquidity, but you have to compare the value of the security they provide with the cost of the product — you pay for what you get.”
Underlying all of these choices are essential questions about the tax treatment of various products. “One of the key considerations,” says Dennis Tew, chief financial officer with Franklin Templeton Investments Corp. in Toronto, “is to manage how much income is going to hit their tax returns, taking into consideration government benefits such as old-age security, Canada Pension Plan and the guaranteed income supplement.”
You should also pay close attention to the type of income being generated, Tew adds, bearing in mind that interest income is taxed at the highest marginal tax rate while dividend income and capital gains receive favourable tax treatment. (See story on page B14).
Clients who have a portfolio of mutual funds, says Tew, can set up systematic withdrawal plans that redeem a specified portion of their investments each month for income.
In such a case, the asset mix of the client’s portfolio should be tailored to provide tax-efficient withdrawals. IE