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At Croft Financial Group, have found that generally, the income needs for most retirees exceeds the cash flow being generated by the allocation within a traditional income portfolio (i.e., 50% stocks, 50% fixed income). To offset the shortfall, the portfolio manager must sell assets, which necessitates a drawdown of principal. For many retirees, the drawdowns outweigh the advantages of reduced variability and higher share prices.
Think about it this way. Suppose you have $100,000 in laddered GICs yielding 4% per annum. That portfolio will generate $4,000 per year in income with no tax benefit. If at age 65, your required annual income is $6,000 adjusted annually for a 1% inflation rate, you will be drawing down principal at a rate of $2,000 per year. The portfolio will have zero variability, with a guarantee that you will run out of money before age 85 (see Figure 1).
If the retiree’s principal is being disproportionately eroded, a portfolio generating more income with heightened price variability may be the better approach. Using the same analogy, suppose a hypothetical $100,000 portfolio that includes dividend-paying stocks and option-writing strategies produces $5,000 per year in tax-advantaged cash flow.
Managing the shortfall requires an annual drawdown of $1,000. This drawdown is less intrusive, but it can be painful if it occurs at a time when the portfolio is experiencing a sharp selloff.
To shed light on potential pitfalls linked to Enhanced Income portfolios, we incorporate a “cone of uncertainty,” bracketing best and worst-case scenarios. In this example, because drawdowns are less intrusive, the Enhanced Income portfolio should be sustainable until at least age 92 and could last a lifetime.
But there is a tradeoff. Is a minimum volatility portfolio appropriate if you are forced to draw down excess principal? Or does a higher yielding, potentially more volatile model where the underlying components are more tax efficient (capital gains and dividends versus interest income) and offer the potential of higher payouts over time (i.e. dividend increases) provide a better solution for income-oriented investors?
How do taxes fit into this discussion? Interest income is taxed as ordinary income, which means you pay the marginal tax rate on total cash flow. Dividends from common and preferred shares and capital gains from option writing strategies are more tax efficient, which may require less of a drawdown to end up with the same after-tax cash flow.
Going back to our previous example, $6,000 of interest income on the hypothetical $100,000 GIC portfolio will, depending on your marginal tax rate, deliver approximately $4,000 of after-tax income. The alternative income model delivering the same $6,000 in dividend and capital gain income will leave you with about $4,800 in after tax income.
And what about inflation? A reluctance to deal with significant government deficits have historically been inflationary. Cost-of-living adjustments to your monthly income can have an outsized impact on principal drawdowns. Rising dividend payouts act as a counterweight to those risks.
In our experience most investors cannot survive on the income generated by a laddered GIC portfolio or an annuity. It simply does not generate enough cash flow and cannot effectively offset inflation expectations. In the real world, we need to step outside the GIC and annuity spectrum, into either a more traditional income allocation (50% stocks, 50% fixed income) or a more tax-efficient alternative income model that focuses on value stocks with solid dividends, preferred shares, and bonds bolstered by option-writing strategies.
Choosing a traditional versus alternative income approach rests with investor’s ability to tolerate increased portfolio variability. The alternative income model theoretically carries greater risk both in terms of price variability and the fact that corporations can withhold dividends to shore up balance sheets (note: management determines whether to pay or withhold a dividend, which hinges on current economic trends).
We can deal with the second element by selecting companies where there is a high degree of probability that the dividends will be maintained. Ideally, we want companies that have increased dividends over time thus providing the best of both worlds. Investors enjoy the tax advantages that come with dividends and benefit from increased cash flow that supports inflation adjustments.
The variability question hinges on the investor’s risk tolerance, which is more theoretical than factual. For one thing, the reduced variability in the traditional income model assumes that bonds and GICs are a low-risk alternative, which is not always the case. Still, an equity-based portfolio that pays dividends supplemented by a well-thought-out option-writing program will, by definition, be more volatile.
Unfortunately, portfolio managers rarely know how much variability a client can absorb until the investor experiences downside price action or extended periods of underperformance. The advisor’s job is to help manage the emotional roller-coaster so the investor can weigh the benefits versus the risk and hopefully stay the course until better times emerge.
The alternative income model is a viable option for certain investors. It will appeal to investors where their required income can be attained without significant drawdowns on principal.
It is appropriate for investors who think about the alternative income model in much the same way as they think about a pension plan. To that point, investors must have a pre-defined and consistent income objective. One would not make one-off requests for funds from their pension administrator. That same discipline must apply to the alternative income mandate.
Periodic requests for supplemental withdrawals typically result in asset sales (i.e., principal drawdowns). Usually, these sales occur during market declines which historically have had a profound impact on the viability of the strategy.
Ideally, income investors who are willing to gravitate to this type of model would define their required income needs within the context of the cash flow being generated by the model. On that note, one should set their required income at a rate that is not greater than 70% of the cash flow being generated by the portfolio. For example, if the portfolio generates $5,000 annually through dividends and distributions, the required annual income should not be greater than $6,500.
Investor behavior is also critical. Those who can focus on the stability of the cash flow while discounting the variability of monthly and yearly return data will be in a better position to reap the many benefits of the alternative model. To that point, I encourage investors to immediately begin drawing monthly income. Ideally, the consistency of the cash flow will in time (usually six to 18 months) alleviate concerns about portfolio variability.
That latter point is particularly relevant during the initial “black swan” selloff during the pandemic shutdown. While the decline was draconian, it had no impact on the portfolio’s cash flow, proving once again that the worst thing one can do is exit a viable long-term strategy because of a short-term aberration.
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
Disclaimers
Content © 2024 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
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