Income investing in a low-rate world
Having an investment income strategy can be important at any age, but it should be a priority if you're retiring soon or already there.
Assess your needs, resources
Being a successful income investor starts with taking time to assess how much income you really need and where that money will come from.
It's often suggested that replacing 60% to 70% of your pre-retirement income will maintain your lifestyle after your working days. But the truth is no single rule is right for everyone; much depends on your own circumstances, goals and objectives.
What do you spend on basic items such as food, transportation, shelter, health care and taxes? Maybe you plan to downsize to a smaller residence. If you're about to retire it's a good bet you'll need less for commuting, wardrobe and lunches, while making pension and EI contributions will be a thing of the past.
On the other hand, as you age, you should anticipate spending more on your health. Lifestyle choices will also have a major impact. Travelling the globe will require a lot more cash than puttering away in your garden. Frequent dining out, golf club memberships or maintaining a recreational property all demand a larger budget.
When it comes to paying for it all, pension plans can do much of the heavy lifting. Based on current maximum Canada Pension Plan (CPP) and Old Age Security (OAS) payments, a couple can receive nearly $35,000 a year from the government alone. Add to this a workplace pension and the good news is you might have to generate less income than you think.
Retiring early demands a savings pool large enough to cover expenses until your pensions kick in. If you're counting on receiving CPP before 65, ask your advisor how changes to early collection rules and calculation methods beginning in 2011 may affect your decision.
Building your income portfolio
Investing solely in government bonds or term deposits will all but eliminate risk to your capital. But the reality is you may not earn as much as you'd like in a low-rate environment, especially after adjusting for taxes and inflation.
On the other hand, choosing investments offering higher rates means taking on more risk. The market value of those investments may decline, payments to you may be interrupted or reduced, or your full principal may not be returned. After you retire and your paycheques stop, replacing any losses will be even harder to do. Building an effective income portfolio takes the right balance of risk and reward.
Developing your core
A sensible income strategy for most people starts with a core position in federal and provincial bonds* or bond mutual funds* (typically a diversified mix of government debt and high-quality corporate bonds) and term deposits. These traditional income choices deliver predictable cash flow and help anchor your investment portfolio.
Even with today's relatively low rates on safer investments, there are ways to stretch your core income. For example, check out our short video on a simple yet effective technique known as laddering to get more out of your term deposits.
Spread your money equally among a mix of shorter and longer terms, say from one to five years. As your holdings mature, simply reinvest the funds in new five-year terms. This gives you access to a portion of your funds each year if you need them, and helps eliminate the rate shopping cycle, since you benefit from the higher rate of return typically linked to 5-year investments.
Adding yield sensibly
Once you have established your core position, look to enhance your income while staying within your risk tolerance.
More than growth vehicles, equities can also power your income strategy. Dividend-paying stocks*, income trusts*, real estate investment trusts (REITs), and preferred shares* can deliver higher regular payments than most fixed income choices. Even a small pickup in yield can make a big difference.
For instance, say you boost the overall yield of your portfolio from 3% to 4.50%, achievable with the right asset mix. While it's only a 1.5% change in rate, it translates to a 50% increase in income. Plus, equity income investing is tax smart. If the extra cash comes from dividends issued by eligible Canadian corporations it qualifies for the dividend tax credit when held outside a registered account. And unlike interest payments that are fixed until maturity, dividends can grow with a company's success.
Depending on your situation, you may prefer to put your money to work through mutual funds*, in a broadly diversified investment that's easier to manage.
The growth potential of equities can play a key role in maintaining your portfolio's income-producing ability. Because stocks are generally less sensitive to rising interest rates and inflation, they help shield the value of fixed income holdings.
If you're attracted to the benefits of equities but don't like dealing with the market's ups and downs, you may want to consider segregated funds.
Like mutual funds, segregated funds† are professionally managed pools of savings. But as insurance products, they offer important advantages. Up to 100% of your capital can be protected. What's more, upon death your investment can go directly to your named beneficiaries and bypass your estate, saving probate and related expenses. There can be important conditions or limitations around segregated funds, so ask your advisor if they're a good fit for you.
Converting your RRSP to income
You've worked hard to build up your retirement savings. But now that it's time to turn those savings into income, what are your options?
Current rules require you to convert your RRSP to a retirement income option by the end of the year you turn 71. The most popular choice is a Registered Retirement Income Fund (RRIF). A RRIF allows you to keep your retirement funds taxed sheltered, an important advantage in preserving your capital. You can choose from the same range of eligible investments as your RRSP, so you can easily customize your income plan. Withdraw as much or as little as you need above the mandatory requirements. After death, the remainder of your RRIF can be left to your heirs.
While a RRIF offers a combination of tax sheltering and flexibility that's hard to beat, it's not a hands-off investment. Make bad investment decisions and your assets and income stream may be at risk. That's why for some, annuities are an attractive alternative.
With an annuity there's no guesswork. It's an insurance contract that offers steady, predictable payments either for life or to a specified age. These payments continue regardless of what the market or interest rates do. So if having peace of mind and simplicity are priorities for you, annuities may fit the bill. However, once an annuity is purchased, you no longer have control over the investment money used and your funds cannot be returned.
Generally, the more you invest in an annuity, the higher your payments will be. How much you'll receive also depends on where interest rates are and how long you want your payments to last. For example, choose a longer contract and you'll receive less. Because traditional annuity payments are fixed, even low-level inflation can hurt. Inflation of just 2% annually will eat away a quarter of your income in 15 years.
When interest rates are low, like they are now, it takes a larger lump sum to secure reasonable income with an annuity than when rates are higher. This makes annuities relatively expensive in the current market.
One approach to managing interest rate risk, inflation and the cost of annuities is to avoid putting all of your savings in at once. Instead, consider purchasing a series of smaller annuity contracts to spread out your risk and let you take advantage of possibly higher rates in the future.
Choosing between annuities and RRIFs isn't an "either-or" proposition. Instead, you can combine these options in managing your retirement income. You'll benefit from guaranteed cash flow, while having the flexibility to add yield or alter your investment strategy as your needs change. Alternatively, you can start out with a RRIF in the early years of retirement and then switch to an annuity when you're older and no longer wish to actively manage your investments.
When rates are high, income investing becomes a simpler task. In the current low-rate environment, creating enough income takes a solid plan that looks at all of your options. Don't fall short. Your BlueShore Financial financial advisor has the knowledge, experience and skills to thoroughly review your situation and help create a balanced approach to the income you need.