Jul 30, 2007

Increasing Your Share of Investment Returns - Part 2

by: Stephen Lowrie

When creating the cash flow you need for a long, secure retirement, it’s important to compare the way different cash-generating investments are taxed. In this, the second in a three-part series in “Views,” you’ll see how the amount of tax you pay on investment income derived from bonds and GICs, Canadian dividends and equity Systematic Withdrawal Plans (SWPs or synthetic dividends) can have a significant impact on your net profit from your investments. You’ll also gain ideas on how to keep your cash flow – and investment portfolio – healthy.

In Part Three of “Views,” I’ll offer strategies on how to keep management fees low, another important part of a successful investment experience.

Increasing Your Share of Investment Returns: Part Two

How can you choose the income option that gives you the cash flow you need while staying tax-efficient – without undue portfolio risk?

Investments grow tax-deferred within an RSP, which means income from your investments is not taxed until it is withdrawn from your RSP. But when looking at investments outside an RSP, you should know that investment income becomes a part of your income and is subject to taxation. Each type of investment income – interest, dividends and capital gains – is taxed at a different rate. For 2007, the tax rates for an individual in Ontario in the highest tax bracket are: interest 46.2%, dividends 24.6% and capital gains 23.2%. I’ll review three popular income-generating options: bonds and GICs, Canadian dividends and equity SWPs. (For the rest of this article I will refer to equity SWPs as Synthetic Dividends.)

Do you want income or cash flow?
A key to a happy retirement is generating a sustainable, reliable stream of cash flow from your investment portfolio that has an acceptably low probability of depletion. This comes in the form of “a retirement pay cheque” each month through a process that emphasizes stability and total return.

Cash flow can come from income, where a company sends you an interest or dividend cheque, or through the sale of securities on which you realize capital gains.

Let’s look at the difference between income and cash flow in retirement planning. Income comes primarily from bond interest and stock dividend payments, while cash flow uses both a combination of interest, dividends and selectively liquidating securities to create retirement income.

Focusing on cash flow allows you to maintain your lifestyle in a tax-efficient way. The pursuit of income generation can actually increase risk and reduce your after-tax profit from your portfolio. Remember, your goal is to keep as much of what your portfolio generates as possible. Most investors are farther ahead when they seek cash flow, rather than income, from their portfolio.

What kind of portfolio do you need?

You are best served to first set up a portfolio to match your financial planning and lifestyle goals, i.e., with a focus on a portfolio return goal within an acceptable risk level. Then, look at your cash flow needs using your portfolio as a solid source to fuel your retirement.

Why not focus on investment income generated by your portfolio to meet your lifestyle needs?

Some investors see bonds and other investments as easy ways to pay bills during retirement. They look to equity investments to drive the growth of the portfolio, while the bonds and other income-generating investments literally pay the bills and lope along, faithfully generating income each year. While this may be convenient, it is a risky strategy.

The first risk is that this strategy tends to drive a portfolio out of balance because you are taking all of the income from a lower performing asset class. For example, suppose you start with a 50% bond/50% equity asset allocation and derive income from the bond portion while letting the equities grow. Remembering that historically the return of equities have been much higher than bonds, after a few years your equity allocation might grow to 60% or 70% of the total. A portfolio with a 70% allocation to equities is much riskier than a portfolio with a 50% equity allocation. So by doing nothing, you have actually increased the risk level or your portfolio each year.

The second major risk is that pursuing higher income investments can lead to taking on riskier, i.e., low credit quality investments. When you use the income solely generated from your bond holdings to pay your bills, you need to extend maturities beyond five years, take on more credit risk, or both. Economic theory suggests that investors are not compensated enough in higher returns for taking on these types of risks.

Finally, this strategy usually creates more tax – another risk.

Financial security is centered on sustainable, long-term net worth, not marginal income generated along the way.

It’s also about balancing present and future income/cash flow and principal protection. Holding long-term or lower creditworthy bonds in pursuit of income can put principal at risk. The sole advantage is that you get cash flow from your portfolio without making any decisions. But why choose this option when you could be faced with really tough decisions down the road triggered by unexpectedly high inflation and other factors that could ultimately influence your net worth? Financial security is centered on long-term net worth, not marginal income generated along the way.

Better to generate cash flow by security sales from your portfolio.

This strategy is beneficial as it specifically targets over-weighted asset classes and automatically rebalances your investment portfolio to keep it properly diversified among different asset classes. Capital gains are taxed at a lower rate, as well. The only drawback is psychological, as many investors don’t like selling off portions of their portfolios to generate cash flow.

Let’s look at some specific income-generating options.

Bonds and GICs
Bonds/GICs are considered a relatively “safe” investment among retirees who need to rely on a steady source of income and need to protect their capital.

The problem is that the interest income you receive from these investments is fully taxable. Depending on where you live and your marginal tax rate, as much as half the interest income earned could be taxed. The chart on page 4 shows that by investing $1,000,000 in a GIC that pays 5% and generates a pre-tax annual income of $50,000, an investor in the highest tax bracket would be left with only $26,800 of after-tax cash flow.

After the negative effects of inflation and taxes, the “real return” on GICs over the past five years has been zero or negative. A study entitled, “The Erosion of GIC Returns by Income Taxes and Inflation”* concluded that an investment portfolio would be seriously depleted if fuelled substantially by rolling over GICs outside of a registered plan.

Canadian dividends
The federal government recently reduced the effective tax rate on eligible Canadian dividends by enhancing the dividend tax credit. Dividend-paying investments, therefore, now offer a more tax-efficient cash flow, usually outperforming interest-generating investments. Please see the chart on page 4 for a look at the potential returns earned on an investment of $1,000,000 in a dividend fund that earns a return of 7% annually, 50% derived from Canadian dividends and 50% from realized capital gains.

Synthetic dividends or equity SWPs
Redeeming assets or creating your own synthetic dividend (or systematic withdrawal plan) can help you create cash flow from a non-registered portfolio while managing tax and costs.

Synthetic dividends feature tax deferral benefits (as most of the distributions are a return of capital and not subject to tax). You can also use these redemptions to rebalance your portfolio, selling shares of assets that are over-balanced relative to their target weight. (Viewing your portfolio in one large snapshot is better than looking at it as a series of smaller photographs taken from several different angles.)

Rather than drawing cash from a high-yielding strategy loaded with risk that might not pay off, it is wiser to reduce bond risk and redirect the saved risk to equities where the expected return is higher. This provides strong cash flow, good liquidity and the opportunity to achieve growth and stability within your investment portfolio.

Assumptions: Tax rates are based on an Ontario resident in the highest marginal rate. Tax rates: Interest (46.4%), Dividends (24.6%) and Capital Gains (23.2%). Tax rates are for 2007 and are subject to change.

*Note: The amount of income tax is small because the vast majority of annual cash flow is treated as a return of capital. The actual capital gain is $6,542, of which $1,062 would be paid in tax. This taxable income will vary each year, depending on the amount of the ACB withdrawn annually.

*Mawani, A., Milevsky and Landzberg. “The Erosion of GICs by Income Taxes and Inflation.” Canadian Tax Journal (2004): 1057-1075.