Income solutions for everyone

The divide used to be fairly clear: Equities for the young ’uns, income solutions for retired folks. The mere mention of the word “dividend” to a pre-retiree sitting across your desk might have drawn stares.

But in today’s environment of heightened volatility, more and more investors and advisors alike are discovering what some have known for a long time: Cash flow is important in any plan, especially when stocks are having the kind of bumpy ride we’ve seen recently.

Equity and fixed-income

“If you look at the IFIC data, you’re seeing money flowing into fixed-income funds, into balanced funds and into income funds,” says Dennis Mitchell, vice president and senior portfolio manager with Sentry Investments in Toronto.

Obviously, investors are starting to fixate on cash flow.

But income solutions include a wide variety of investments, so how do you choose the best products for your clients?

“In general,” says David Miner, financial advisor with Equity Associates Inc. in Toronto, “the younger we are, the bigger the component in equity we should have.”

That said, bonds and other fixed-income products can help balance out the risk that accompanies large equity holdings. To accomplish that, Miner suggests a wrap portfolio for younger clients, “where there might be a small fixed-income component that adds to the overall stability.”

In this scenario, “the portfolio manager isn’t locked into equity, [and] if equity markets get frothy, he or she can hide a little bit in the fixed-income market,” explains Miner. “Most of what I do is balanced in some fashion. I’m big into risk management, and bonds really are very good for helping you to temper volatility.”

Jeanette Brox, CFP, senior financial consultant in the Toronto Central office of Investors Group, believes choosing the right products for clients ultimately depends on their timeframe, their purpose, what they’re doing with the money and how soon they’re going to need it.

For many clients, guaranteed income funds (GIF) may be a way to go.

“A lot of professionals want to take a look at these products,” Brox says. “Since the GIF is an insurance product, one of the benefits it provides is for long-term investment growth potential with the protected guarantee feature to help minimize risk.

“These products are good for [professionals and business owners],” she asserts, “because they can provide creditor protection. I find, too, that a lot of my business and professional clients take a fairly long-term view, so they get kind of excited when you start talking about estate management and minimization of probate fees—how to preserve and protect their hard-earned dollars.”

Brox is also a fan of dividend funds. “Dividends aren’t guaranteed, but if you look at the quality investments, like the banks, insurance companies, utility companies, they’re cash cows. They pay out those dividends religiously.”

A dividend fund that holds such companies can let investors make “a substantial amount of money and pay very little in taxes because of the dividend tax credit. [It’s] much better than a GIC, which would produce income [but] wouldn’t even keep ahead of inflation and would lose so much to taxes.”

Miner warns against handcuffing a portfolio manager, though, as it’ll tie down performance.

“The higher the yield on the bond or equity, the more it cushions market volatility. The math is absolutely common sense. But as an advisor, do I want to go out and sell clients high-yielding preferred stock or dividend funds? I’d rather say to a portfolio manager, ‘I want a balanced portfolio. I’m sure you understand the way dividends cushion volatility, so here’s the money. You figure out now what to do.’ ”

Total-return approach

Drew Abbott, vice president and investment advisor at TD Waterhouse, Toronto, says nine out of ten of his clients have an income component in their portfolios, whether it’s bonds, preferred shares or something else. But typically, he says, returns came from growth, and dividends were merely a pleasant byproduct.

“In the past,” he explains, “people put a portfolio together and had a target rate of return—say 7%—on an overweighted equity but somewhat balanced portfolio. So that 7% return typically came from growth: Buying companies at a certain price and selling them at a higher price to hopefully achieve your targets. Dividends were strictly a way to create income, and kind of a bonus.

“But nowadays, given what we went through, there’s been more of a focus on total return. So if [a client’s] goal is 7%, and if we can go out and get, say, a 3% dividend on a basket of conservative stocks, that means we only need 4% growth, so it automatically becomes a more conservative portfolio, which is what people want.

“People aren’t looking to shoot the lights out,” Abbott continues. “They’re looking for wealth preservation and then modest growth and income after that. So income solutions aren’t just for income. They can be for the overall growth and target of the portfolio.”

What does Abbott like for his clients? As Brox noted, it depends on what their goals are.

For “a very conservative but pre-retirement client [who] doesn’t have enough wealth, is earning 1% fully taxable in their bank account and has to start looking for alternatives, I’ll start dipping their toes in the water with income products on the really conservative side, like short-term government bonds. But as we step out a little bit, you can look at something I’ve used quite often, especially in the last two years—reset preferred shares. They have a time limit, typically a five-year time frame, and they pay a very tax-efficient dividend.”

Abbott says this product is ideal for clients who can’t withstand five years of getting 1.5% from their money-market fund or bank account.

An added benefit is reset preferreds are issued by banks and some “pretty stable companies,” such as Brookfield and TransCanada Pipelines. And in the event of insolvency, these preferred shares have preference over common shares.

But at the same time, he warns that advisors need to manage their clients’ risk tolerance and make sure they understand every investment carries risks. A strong spike in interest rates, for example, will negatively affect existing bonds and some preferred shares. And a major correction or double-dip in the markets will bring down the share prices of dividend-paying companies.

“So if [an investor] has a time frame of one year and wants income, he or she is certainly not going into these [investments],” says Abbott. “But if he or she has a five-year-plus time frame and can withstand the gyrations in the stock market, then they’re probably suitable.”

Dividends mean better performance

Says AGF Management portfolio manager Peter Frost in Toronto, “A little bit of consistent income is a good thing to have.” In his opinion, investors should expect a cash payment if they’re going to commit their capital.

“My philosophy goes back to the way they used to do it a hundred years ago,” he says. “If you invested in an equity, you got paid through a cash dividend—and you expected it. That is what you’re paid to commit your capital.” With a bond, “you’re getting a coupon,” he adds, “but with equity, people don’t think of a dividend first.”

Frost says dividends should be front and centre. If a client invests in a company, he or she should get a reward for committing capital to that company in the form of a dividend.

“I would say companies that are growing their dividends are the ones you want to invest in for the long term,” says Frost, citing research from RBC Capital Markets Quantitative Research going back to December 1986 in the Canadian market and ending March 2010.

“They [RBC] looked at the returns of different types of companies based on their dividend policies. And they started with companies that didn’t pay a dividend—and from 1986 to March 2010, those non-dividend payers only returned 1% per annum. They then looked at companies that paid a static dividend; they returned 10.3%. Finally, the best performance came from those companies that were increasing their dividends. They returned 12.1%.

“So you can see, not only is it a great strategy for people who are just looking for income at retirement age, it’s a great strategy for any investment horizon.” Frost says many companies have been rapidly increasing their dividends for decades.

Colgate-Palmolive, for example, started in the 1800s as a soap company, but now it’s highly diversified. If you went back 20 years and bought a share, how would you have done?

“If you started back in 1990, the share was trading at $7.59. Fast-forward to October of this year, not quite 20 years, and you as an investor would have received about $16.50 in dividends, and your share is now worth $77.12. And this is a company that’s paid a consistent dividend since 1895, and has increased its dividend every year since 1963. This just goes to show you the power of finding those companies committed to rewarding their shareholders through an increasing dividend.”

Asked if Colgate-Palmolive is an oddity, Frost says dividend-growing companies exist in every sector. Take Clorox Co. It has increased its dividend every year since 1977—and by over 13% per annum over the past five years.

If your client is seeking a high level of income, Frost recommends investing in more mature companies. They don’t have a lot of investment going back into the company to maintain it, so they pay out upwards of 80% of their profits. A good fund manager ensures the income is stable, and that it remains stable.

Lower risk, more stable returns

Dennis Mitchell is responsible for two funds at Sentry Investments, Toronto: One focused on REITs and one on infrastructure. “We’re trying to deliver very consistent, stable income streams, and that usually results in some very consistent, stable returns as well,” he says. And investors appear to be supporting his firm’s approach.

“The funds flows, in the REIT fund in particular, have doubled from $1 million a day to $2 million a day,” he says, but adds it’s a short-term trend because of the impending trust tax on distributions from publicly traded income trusts and limited partnerships.

For this reason, Frost says many income trusts are reverting back to a corporate structure, which should ultimately give them more flexibility and a larger investor base that stems from the certainty of limited liability under a corporate structure.

That said, says Mitchell, “essentially what you’ll find is that business trusts, infrastructure trusts and oil and gas royalty trusts will become taxable at the corporate level. The important thing for people to realize is you can only tax taxable income. So if you have a lot of tax shields in your income statement, then you probably aren’t going to be taxable.”

He cites Brookfield Real Estate Services Fund as an example. Brookfield has very few assets; its business is based on residential real estate agents selling homes. There’s very little in the way of hard fixed assets and depreciation, so they generate taxable income and will pay taxes. On the other hand, Chartwell Seniors Housing REIT pays very little tax because of numerous tax shields in its income statement. It has a lot of fixed assets—seniors’ housing facilities, for one—which it depreciates down as a non-cash expense that’s deductible for tax purposes.

To each his own

Regardless of the income solution you select for your clients, it’s clear your decision must be based on clients’ risk tolerance, current portfolio construction and time horizon.

In the end, if your clients sleep better at night thanks to an income stream, potentially less volatility and increased returns, then it’s the proper solution.

Exotic may not mean risky

David Salloum, CFP, vice president and portfolio manager with The Salloum Wealth Management Group at RBC Dominion Securities in Edmonton, often uses covered call writing on solid stocks to provide his clients with income. But “this strategy is for income, not necessarily growth,” so he admits it’s not a good fit for everyone.

“It all depends on the client and what they have [in their portfolio], their asset allocation, their time horizon,” he says. “It’s all part of their overall financial plan.”

Despite investors associating the word “derivative” with risk, covered calls are a very conservative option strategy, Salloum insists. But he warns that advisors should only consider covered call writing in situations in which either the investor is comfortable holding the stock if the option isn’t exercised or is comfortable selling a stock at a certain predetermined price.

For example, with covered call writing, an investor owning a stock (we’ll call him Bob) can sell a call option giving another investor (we’ll call her Mary) the right to buy 100 shares of the stock from Bob at $X per share—the strike price—by a particular date (each contract is 100 shares).

Bob receives a premium for each contract sold. If the stock price rises above the strike price, Mary will either buy the shares or sell her option. Bob earns the premium per contract ($X per share) and any dividends paid while he holds the shares (note that Mary has the right to early exercise of her option, and might choose to do so if the stock is above the strike price and a dividend is about to be paid). Dividend payments may not occur in all cases.

If the stock price doesn’t exceed the strike price by the expiration date, then Bob still owns the stock, and may decide to write another option with a later expiry date, earning another premium and potentially more dividends.

Salloum gives the following example. “We recently bought a client 1,000 shares of a large bank at $74.50 a share. We then sold $76 call options, and in this case, the client received a $2.54 premium per share.”

So it looks like this:

$74,500 Initially spent to acquire bank shares (plus a commission or fee, depending on the type of account the client has and what the advisor is charging)

$76,00 Generated on the sale of stock (assuming the option is exercised)

$1,500 Earned on the sale of the stock (exercise of option)

+$2,540 Premium earned, taxed as a capital gain (10 contracts x 100 shares x $2.54 per share)

+$4,040 Return (5%) in 162 days

“Then, add in the dividend earned during that time and it annualizes to approximately 11%,” says Salloum.

“Together, the capital gains and dividends received would make a very nice return for the investor.”

And if the strike price hadn’t been met, the client would still have earned the premium and the dividends, and would still hold the stock and could look at writing another option.