Income fix

(April 2006) To help clients generate sufficient retirement income, advisors must outline strategies that will take advantage of the good times but will also assuage clients by withstanding volatility in the equities markets.

Many Canadians will need to use all or most of their investment assets to maintain their current lifestyles throughout the retirement years, or to comply with income tax regulations, such as the statutory RRIF minimum. In a properly diversified client portfolio, an advisor strives to minimize the risk of stock market volatility while accumulating assets, but diversification may not be enough once the client starts taking income from the accumulated savings. To make the most effective use of retirement income resources, I suggest the following:

• Develop an investment policy statement (IPS) that captures your client’s unique objectives — along with his or her particular risk tolerance.
• Design a tailor-made and detailed retirement income illustration for your client. This allows you to estimate how much income can be generated from investment assets, pensions and any other income entitlements. The illustration should report the results in a net spendable income form (after-tax and after-inflation).
• When estimating a client’s life expectancy, add at least five or 10 years, since national statistics are based on medians — in other words, half of the people will die before and half after the stated age.
• Construct an investment and withdrawal strategy for your client.

SEEK BALANCE

In generating retirement income, it’s important to avoid withdrawing funds from asset classes that are declining in value. If your client is unlucky enough to retire when the stock market is performing poorly, he or she could deplete capital at an alarming rate, and reduce the chances the portfolio will be able to generate the required net spendable income for her expected lifetime.

For example, the average Canadian balanced fund earned 7.4% over the past decade, according to Morningstar. If $100,000 was invested in such a fund 10 years ago, with income being withdrawn at a rate of 7% ($583 per month), the account would be worth approximately $107,700 today.

From this, it can be assumed a 7% withdrawal rate from a balanced portfolio allows a client to maintain capital. However, if $100,000 was invested in the same average Canadian balanced fund five years ago, and the client withdrew $583 each month, the account would be worth approximately $75,600 today.

Why the difference? In the first scenario, the market performed very well for the first five years — enough to build a sufficient cushion for the client. When stocks turned down for a few years, the portfolio was able to weather the storm. But in the second scenario, the portfolio never had a chance to develop a cushion, so it took an immediate hit. This illustrates why it’s difficult (and impractical) to try to plan retirement around the short-term performance of the stock market. It’s also the reason I generally recommend clients not withdraw at a rate of more than 5.5% in a given year.

But there is a way to create a cushion for the client, even in a dipping market. I suggest the following strategy to each of my retiring clients:

• Invest one year’s income from the retirement portfolio in a money market account that will be used for the first year’s retirement income.
• Invest another year’s worth of income in a fixed income product, such as a one-year bond or GIC.
• Invest a third year’s income in a two-year bond or GIC.
• Invest the balance of the investments in a growth portfolio based on the results of your client’s IPS.

It’s important the fixed income vehicle (bond or GIC) be owned directly by the client, and not through an institution such as a pension fund. This avoids the impact of unpredictable market conditions on the fund’s values and also allows the client to control both the maturity values and the maturity dates. Bond funds or mortgage funds are also not suitable for this purpose because they fluctuate alongside interest rates.

The strategy assumes the money market account will deplete itself during the first year. If the stock market performs poorly and the growth account loses value, then the maturing GIC should be used to replenish the money market fund. The GIC serves as a reliable source of backup cash to keep the client’s income levels at expectation, even if the stock market can’t provide the returns. Of course, if the stock market performs well, use a portion of the client’s growth portfolio to replenish the money market account and fund the next retirement year. Likewise, if the GIC isn’t used for income, it should be re-invested for two years. That puts funds in place to serve as guaranteed income should stocks perform poorly down the line.

This strategy works because income is being withdrawn from a separate account, instead of from the declining portion of a client’s portfolio. Unless there’s a stock market falloff lasting more than three years, the client won’t be forced to take income from his or her investments while they’re dropping in value. Implemented properly, this strategy lets clients keep their hands off their capital for at least three years.

Using the previous example, if $100,000 was invested 10 years ago with the aforementioned withdrawal strategy in place, the portfolio would be worth approximately $105,500 today. This is about $2,000 lower than if the entire account was invested directly in the average Canadian balanced fund. But that $2,000 is a small price to pay for the security, because if that same $100,000 had been invested five years ago, in an average balanced fund, and with the withdrawal strategy in place, the portfolio would be worth only $87,000 today. That’s a decline of roughly $13,000, so the protection strategy acts to increase the portfolio’s lifespan.

MANAGE EXPECTATIONS

The portfolio has to be monitored and each year the client must consider market returns and decide whether to take the following year’s income from the fixed-income portion or from the growth portion of the account. In years when the market makes extraordinary gains, not only should the growth be used for income purposes, but gains should be capitalized upon and additional funds moved to the fixed-income portion of the account. Doing that rebalances the portfolio.

One of the most difficult aspects of any client relationship is to convince people to focus on diversification as a long-term investment strategy. Investors tend to overreact during rising or falling markets. They often start buying a certain stock, or stocks within a specific sector, after the media has hyped them and much of the price growth has already taken place. As a result, just prior to a market correction, average investors end up holding portfolios that are heavily weighted in asset classes that have demonstrated the best short-term performance. And that means those portfolios often decline dramatically when the stock market corrects. Further, during declines, clients like to transact frequently in their accounts, as it gives them the sense that something is being done on their behalf. But, in reality, all that extra trading tends to fuel declines and racks up additional fees and costs for the clients.

My strategy is to instead move clients’ attention to the long-term nature of retirement-income planning. This is achieved by drawing income from the profitable positions in a portfolio, rather than trying to persuade them to stay the course on their diversified portfolios. If you can do that, the clients will be able to focus on income generation rather than the absolute rate of return in their portfolios from one year to the next.

This approach allows you to rebalance the client’s portfolio as required, and demonstrate that you’re providing them with value-added service by actively managing their accounts. Ultimately, increased service levels lead to improved client satisfaction. In addition to being easy to explain and understand, this strategy gives clients comfort by combining capital protection with growth possibilities.

This article originally appeared in Advisor’s Edge. Clay Gillespie, CIM, CFP, is a vice-president, financial advisor and portfolio manager at Rogers Group Financial in Vancouver. advisorsedge@rmpublishing.com

(04/13/06)