Arlene Tober has nearly 15 years experience in the financial services industry. She achieved the Certified Financial Planner (CFP) designation in 2008.
As the income trust conversion deadline approaches in 2011, many investors are left wondering how to replace the lofty monthly income payouts you’ve enjoyed. For those in retirement, any loss of income could result in a big bite to your standard of living, or you may need to eat away at your capital sooner than expected. It’s important to start planning now in order to ensure a smooth transition.
Most income trusts will convert to corporations that pay dividends to shareholders. While dividend payouts will have to remain attractive to maintain shareholder value, it is likely that most distributions will be lower upon conversion. However, given the preferential tax treatment of dividends, on an after-tax basis, payouts may be similar. Currently, the S&P/TSX Income Trust Index is yielding about 8%, while the yield on the S&P/TSX Canadian Dividend Aristocrats Index is approximately 5%. If income trusts can deliver similar post-conversion dividends, investor income should remain stable.
However, there are other factors that may impact investors. Dividend-paying stocks and funds tend to distribute cash quarterly, which may be limiting for some investors. Some income trusts have indicated the intention to pay dividends monthly to compensate investors but this is not guaranteed.
In addition, corporations know that increasing dividends help support shareholder value. Companies with a history of raising dividends are generally rewarded with capital appreciation; those that cut tend to be severely punished. On the flipside though, a rising dividend yield may be the result of falling share prices, which may be a signal of a bigger problem. If you intend to hold stocks directly, do your research to find which companies have a solid long-term trend of raising dividends.
If you’re not interesting in spending the time to research individual stocks, there are several ways to access diversified portfolios that generate income:
- Dividend Mutual Funds. These are the plain vanilla, tried and true workhorses of the investment world, providing dividend income from a portfolio of stocks that is determined by a portfolio manager who attempts to achieve better than index performance. While these funds tend to provide solid long-term returns, they also can be pricey, with management fees over 2.5% in some cases. That means less of your money stays invested than with cheaper investment vehicles, and most mutual funds do not outperform their related indexes as a result.
- Exchange Traded Funds (ETFs) - ETFs are like mutual funds, offering a diversified mix of holdings. The majority of ETFs are passive in nature, meaning no one makes investment decisions to determine their holdings; typically they are based on an index. These passive ETFs also tend to be comparatively cheap, with fees on dividend-focused ETFs up to 60 bps. However, actively managed ETFs are getting noticed as more flexible versions of mutual funds and offer the opportunity to outperform an index at a cost comparable to their passive counterparts. ETFs can be bought and sold just like stocks, making them more flexible than mutual funds.
- Return of Capital Funds - For those investors in need of monthly income, funds that are known as “Corporate Class” or “Series T” funds can provide monthly distributions in the range of 5-7% annual payouts. Income is primarily designated as “return of capital”, generally resulting in no tax consequences – it is your money being returned to you. Once the original capital is exhausted, remaining payouts are taxed as capital gains. Again, this great idea typically comes at a price of up to 3% in management fees.
- Guaranteed Minimum Withdrawal Benefits (GMWBs) – GMWBs are a version of segregated funds, the mutual funds of the insurance world, and offer an income solution that is guaranteed, generally around a 5% distribution. Usually this income is structured as Return of Capital. While these funds may also offer other benefits, such as principal guarantees and death benefits, they tend to be higher cost than mutual funds and are only sold through an insurance-licensed advisor. They also tend to be locked in, meaning that you can’t redeem any assets for your lifetime or for a certain period of time. However, if stock market volatility keeps you awake at night but you would like to participate in the potential upside, these may be an ideal solution.
- Preferred Shares - Often overlooked as a separate category, preferred shares are a hybrid security with features of common shares and bonds. They pay a specified dividend rate, which also receives preferential tax treatment, but generally offer very little equity growth. Preferred dividends must be paid before common share dividends can be paid. This can provide some comfort to those who depend on regular income and don’t need capital appreciation. In addition, in the event of a bankruptcy, preferred shareholders have a preferred claim on assets over common shareholders (but rank below bondholders). Preferred shares may be held in other mutual funds or ETFs, but very few investments are dedicated to this type of security. One of the better options is the JOV Leon Frazer Preferred Equity Fund, with a moderately low management fee of 1.40%. Its distribution yield as of the end of June is 4% and it offers a Class T series with monthly distributions. The no-load version returned a respectable 10.2% for the one year ending June 30th.
As every investor situation is unique, some of these ideas may be more appetizing than others. However, the lowest fee solutions with the best after-tax benefits will help ensure a fine dining lifestyle can be maintained, rather than living on a fast food budget.
What do you end up with?
After-tax Income on $10,000 (with a marginal tax rate of 40%)
| Income Source | Income Reported for Tax Purposes (%) | Income Reported on Tax Return ($) | Tax Payable ($) | After-Tax Income ($) |
| Canadian Dividend Income | 144 | 14,400 | 2,500 | 7,500 |
| Interest Income | 100 | 10,000 | 4,000 | 6,000 |
| Capital Gain | 50 | 5,000 | 2,000 | 8,000 |
| GMWB | Approx 2.5 | 250 | 100 | 9,900 |
| Return of Capital | 0 | - | - | 10,000 |
Source: CRA
The views expressed are those of the author and do not represent a solicitation to buy or sell any investment. Please consult with an investment or tax advisor before investing.
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