Pre-emptive withdrawals one way to combat RRIF depletion

Growing concern about the effect taxation is going to have on registered retirement income funds (RRIF) during a low-rate environment prompted the C.D. Howe Institute to warn against accelerated RRIF depletion due to unrealistic tax rules. In the absence of policy change, advisors may want to consider winding down their clients’ RRSP before they hit the age of 72.

In its report, the C.D. Howe Institute argued the federal government should consider scrapping the RRIF minimum withdrawal rules or adapt the 1992 formula still in use to reflect significant changes that have occurred in both the interest rate environment and the life expectancy of retirees.

In today’s investment climate, retirees with traditionally conservative income-oriented investment portfolios have a much greater likelihood of outliving their retirement assets. The primary reason for this is that the rate of return on fixed-income investments is substantially less than it was 16 years ago. In 1992, the average life expectancy of a Canadian man at age 65 was another 14.9 years, and another 19.1 years for women, according to Statistics Canada.

According to the C.D. Howe Institute, in 1992 the average interest rate on long-term Government of Canada bonds was 8.7%, and on a three-month money-market instrument it was 6.7%. In early July 2008, long-term Government of Canada bonds were yielding 4.1%, and three-month corporate money-market paper was 3.3%.

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Advisors are struggling to find ways to have their retiree portfolio keep pace with inflation and rate of withdrawals. The extra tax burden of forced withdrawals, which will be taxed at the client’s marginal rate, can tip the scales towards depletion since many clients can now expect to live well into their 80s.

Frank Wiginton, a CFP and senior financial partner with Toronto-based Tri-Delta Partners, says eventually clients have to pay the taxman. He says this is only fair, since they have been able to grow their RRSP assets tax-deferred, but by incrementally withdrawing part of their RRSP before it’s converted into a RRIF, they can create a much more tax-efficient retirement portfolio.

Since the RRIF is intended to be used as a retirement income vehicle — and is taxed as regular income — deriving returns from a non-registered portfolio structured to provide capital gains and dividends will slow the tax depletion of retirement assets.

“If people sat down and looked at their overall finances and their incomes coming in, they could likely start withdrawing out of their RRSP when they retire. More and more people are retiring at the age of 60, not the age of 72. The idea is, if I can take more money out of my RRSP at an earlier age, I can control the amount of tax I have to pay,” he says. “Start taking the money out earlier, controlling the tax rate — closer to the 36% tax rate rather than 46% by moving more of that money into tax-preferred income through dividends and capital gains.”

Of course, there is the significant problem of taking a hefty tax hit when the money is pulled out of the RRSP. To solve this problem, for the right clients Wiginton suggests they consider using an investment loan.

One of the benefits of a lower-rate environment is you can take out an investment loan with a reasonable interest rate. The interest on an investment loan is tax deductible. Wiginton says that tax deduction can be used to offset withdrawals from an RRSP.

“You can reduce the value of the RRIF/RRSP starting at an earlier age, through creating offsetting tax deduction,” Wiginton says. “For example, for a client we can set up $200,000 outside of the RRSP. We can borrow $200,000 from your home, lets say. Effectively what I’m doing is taking $200,000 out of the RRSP, but doing it over the next 15 to 20 years, and so it is effectively tax free.”

Wiginton says if clients set up a non-registered investment account that’s borrowed at 5%, it will cost them $10,000 a year in interest costs. He offsets this by taking $10,000 out of the RRSP to pay that interest cost. The interest cost is then directly tax deductible against that income so the client has zero taxable income. Effectively, the client ends up with a $200,000 portfolio that can be used to create a tax-efficient retirement income.

“By taking $10,000 a year out of my RRSP every single year and creating that offsetting tax deduction in interest cost, I can virtually take out $200,000 in one year by creating this $10,000 deduction over the next 20 years,” he says.

This strategy, which is commonly referred to as an RRSP meltdown, can get rid of the extra tax hit. What it doesn’t address is that clients need to grow a fixed-income portfolio in a declining rate environment.

“You want the money invested in dividend income and capital appreciation types of things. Preferred shares are very good. If you want something that’s less volatile than what’s going on in the markets, preferred shares will go up and down exactly the same way a bond will go up in price,” Wiginton says. “But it’s paying you more than the roughly 4% you’re getting on long-term bonds. Many of these high-quality preferred shares, which are offered by companies such as Bank of Nova Scotia, TD and BMO Financial, are offering upwards of 5.5%.”

There are no easy solutions for longevity risk; clients will likely have to allocate some money to higher-yielding, riskier investments. Wiginton says the C.D. Howe’s use of an ultra-conservative 75% bonds/25% money market portfolio to demonstrate RRIF depletion is not realistic for today’s retiree.

“There’s a good chance you’re going to live another 30 years; you can’t afford to do that, even with interest rate returns of 6% or 7%,” he says.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/14/08)

Mark Noble