Split shares separate income and growth

Some investors require growth from their investments.  Others want income.   At times an investment in common shares may offer both income and growth potential.  A structure referred to as a “split share” attempts to separate these two components.

A split share is a structure that has been created to “split” the investment characteristics of an underlying portfolio of common shares into separate components.   This division may be done to satisfy the different objectives of investors.  Typically, these structures consist of a preferred share and a capital share that trade separately in the market.  Together these two securities are known as a split share.

The description may be confusing to some investors, especially since the preferred shares and capital shares trade independently.  A key component to understand is that you do not have to own both components.  Investors generally own either the “preferred” component or the “capital” component (some investors may own both). Conservative investors requiring income may find the preferred component more appealing.  Growth oriented investors may find the capital component more attractive.

In a typical split share issue, the preferred share receives all the dividends from an underlying portfolio of common shares and is entitled to the capital appreciation on the portfolio up to a certain value.  The capital share receives all the capital appreciation on the portfolio above what the preferred share is entitled to but receives no dividends.  The capital component is generally considered riskier than the preferred component.

The following is an illustration of how a split share is created and how the returns are divided between preferred and capital shares.  As an example, a split share may be created by an investment firm by using existing common shares of publicly traded companies.  Let’s use a fictional company called XYZ Bank.

We will assume that XYZ Bank’s common shares are trading on the TSX at a market price of $50.00 per share and pay an annual dividend of $1.50 (or three per cent dividend yield).  To create a split share based on XYZ Bank, an investment firm purchases XYZ Bank in the market and places them in an investment trust called XYZ Split Corp.

The trust then issues one XYZ Split Corp preferred share at a price of $25.00 for each XYZ Bank common share held in trust.  The preferred share receives the entire $1.50 dividend from the XYZ Bank common share.  This produces a dividend yield that is double that of the common share (six per cent versus three per cent) because half as much money receives the full common share dividend ($25 versus $50).  In exchange for the higher yield, the preferred share is only entitled to the first $25 of the value of XYZ Bank’s common shares that lie within XYZ Split Corp.

XYZ Split Corp also issues one capital share for each common share held in the trust.  The capital share is priced at $25 and is entitled to all the capital appreciation in the underlying shares of XYZ Bank above $25 per share for the term of the XYZ Split Corp.  As this illustration demonstrates, the two split share components are:  One XYZ Split preferred share plus one XYZ Split capital share equals one XYZ Bank common share.

There are many types of split shares as well as underlying investments.  One fact that most split shares have in common is the leverage effect.  Generally, at inception a split capital share offers approximately two times the leverage.  Unfortunately, this leverage also impacts investors in a down market.  For example, a 25 per cent decrease in the underlying investment XYZ Bank may translate into a 50 per cent decline in the XYZ Split capital share value.  A split share structure, especially the capital share component, should only be considered if an investor desires leverage.  Do you use leverage in other components of your account?  What is the position size relative to other investments in your account?  What is your time horizon versus the term to maturity of the investment?  This last question is important, as investors often require patience for leverage strategies to work in their favour.

Split shares are originally offered through a new issue.   After the new issue, both the preferred and capital shares trade in the market generally at a discount to their net asset value (i.e. the underlying common share).   Investors interested in split shares would generally prefer shares that trade at a discount as opposed to those that are trading at a premium.

Although the underlying investment(s) may have many shares exchanging hands each day, a split share may have very little trading activity.  As a result the market for split shares is generally very illiquid making the purchase or sale of split shares difficult at times particularly with larger orders.

In recent years, many financial institutions have not issued “hard retractable” preferred shares, meaning that they have a set maturity date.  Instead, perpetual preferred shares have been issued in their place, with no maturity date.  Perpetual preferred shares are interest rate sensitive.  As rates rise the underlying value of a perpetual may decline (and vice versa).  A positive component to the preferred side of a split share offering is that the structure generally has a set term resembling maturity characteristics of a “hard retractable”.  Terms for most split shares are generally five to seven years.

As with any structured product, fees are associated to set up the structure, compensate the investment firms and other ongoing costs.   Investors looking at the capital component of a split share should be asking, “why not purchase the underlying investment directly?”

As with any investment, the main decision to purchase a split share should be based on the outlook for the underlying company over the term of the structure.  Some split shares may be based on a basket of securities in one sector, index, etc.  In these cases an investor should have a positive fundamental outlook for the underlying security and its sector.

Income Splitting With Your Children

Marriage provides the opportunity to income split.  Having children puts you in a position to cut down the tax bill even further.  Understanding these rules and seeking professional advice is important prior to implementing any income splitting strategy.  The following outlines some income splitting strategies with your children.

Employ your children

This strategy is applicable to those individuals who own a business.  Wages paid to your spouse and children may be a deductible expense for your business provided services are performed.  Your spouse or children would include the wages earned as employment income.  This strategy moves income from the higher-income spouse operating the business, who is in a higher tax bracket, to the spouse or child who is in a lower tax bracket.

Capital Gains

A parent can purchase investments that create capital gains in a child’s name.  Non-dividend paying common shares and growth mutual funds are two examples of investments, which may generate a capital gain.  All capital gains are specifically exempted from the attribution rules with respect to property transferred to a minor.  Any resulting gains are not attributed back to the parent.   Income attribution rules will apply on any interest and/or dividend income earned.  At age 18 the investment becomes the property of the child.

Child Turning 17

Some parents may consider giving their children funds to invest.  If a child turns 17 in the year the gift is received then the funds may be invested in a term deposit or GIC with a maturity of one year or greater.  The interest payment will be made in the year the child turns 18 and no attribution will result.  This strategy may coincide nicely with covering the costs of post secondary education.

Estate Freeze

As noted above, the attribution rules do not apply to capital gains.  If a parent has a corporation and they expect the shares of the corporation to increase in value then we recommend that you seek the advice of a tax expert.  In some cases the use of a trust may be necessary.  As an example, let’s use a parent with shares in a private business that were purchased for $10,000 but are now worth $100,000.  If the shares are given to children then a deemed disposition will likely have occurred.  Any resulting capital gain may be offset by the lifetime capital gain exemption (2007 Federal Budget proposes to increase the lifetime capital gains exemption to $750,000 from $500,000 for capital gains realized on the sale of qualifying small business shares and qualifying farm or fishing property).  In future years the children can sell these same shares and also take advantage of the capital gains exemption.  Proper professional advice should be obtained prior to any transfers to children.

Transferring Property

In addition to shares of a private business, parents may want to consider transferring other assets that may generate a capital gain.   Examples may include shares in speculative publicly traded companies, artwork, and jewelry. Proper professional advice should be obtained prior to any transfers to children.

Childcare Expenses

Baby-sitting wages paid to your lower-income adult children or lower-income adult family member (i.e. grandparent) can be claimed as childcare expenses.  The adult children will need to provide the higher-income parent with a receipt and subsequently claim any income.  This allows the higher-income parent(s) to deduct these expenses to offset employment or business income.

Child Tax Benefit

The child tax benefit cheque can be deposited in a bank account in the child’s name.  Income earned on those funds is not subject to attribution to the parent.

Universal Child Tax Benefit

The universal child tax benefit cheque can be deposited into a bank account in the child’s name.  Income earned on those funds is not subject to attribution to the parent.

Registered Education Savings Plan

The perfect income splitting tool relating to parents and children is the Registered Education Savings Plan (RESP).  Although parents that contribute to an RESP do not receive a deduction, they are shifting funds to a tax-deferred vehicle. In addition to the deferral, the child may be eligible for Canada Education Savings Grant.  When the income and grant component (not the original capital contributions) are pulled out of the RESP it is taxable income for the child.  The latest Federal Budget provided some positive changes with respect to RESPs.  A column this summer will be dedicated to providing an update with respect to these changes.

Employment Income

Many children work over the summer months and use those earnings to fund university or other expenses.  The child could invest the $8,000 that they made over the summer.  The higher-income earning parent could pay for the child’s tuition and basic expenses.  If parental assistance is not an option then consider an interest free loan.  After university is completed then the principal amount of the loan can be paid back with the funds the child invested.

In many cases the above strategies result in your child obtaining control of the respective asset.  This is a very important factor for parents to consider.  Saving taxes through income splitting may also be the ideal opportunity to teach your children financial responsibility.

Professional Advice

Prior to implementing any income splitting strategy we recommend individuals meet with their professional advisors.

Income split with spouse requires plan

Our last column explained how the goal of income splitting is to lower the household tax bill.  We also highlighted the importance of understanding the “attribution rules” and the importance of seeking professional advice prior to implementing any income splitting strategy.  Today, we’re outlining some income splitting strategies with your spouse.

Employ Your Spouse

This strategy is applicable to those individuals who own a business.  Wages paid to your spouse may be a deductible expense for your business provided services are being performed.  Your spouse would include the wages earned as employment income.  This strategy moves income from the higher-income spouse operating the business who is in a higher tax bracket into the spouse who is in a lower tax bracket.  If the lower-income spouse has little or no income, then the tax benefits of income splitting should be compared with the potential cost of losing any credits.

Spousal RRSP

The spouse with the higher income can make a spousal RRSP contribution to a plan in the name of the lower income spouse.  The higher income spouse receives the deduction however the funds accumulate for the benefit of the lower-income spouse.  Some individuals may feel that spousal RRSPs will no longer be applicable if pension splitting is allowed.  Unless you can predict your future we would disagree.  There may be an opportunity for you to retire at a younger age than expected.  Possibly you will need some funds from your RRSP for emergency purposes.  Attribution Rules apply if withdrawals are made from the spousal RRSP in the year of the contribution and the following two years.

Spousal Loan

With today’s low interest rates you can arrange a loan from a higher-income spouse to a lower-income spouse at what is referred to as the prescribed interest rate (set by the government). That loan rate is locked in until the loan is paid off. The lower-income spouse then invests the loan proceeds in their own name to generate investment earnings.

The interest on the loan is deductible to the spouse paying the interest but must be included in income by the other spouse. For this reason, the investment income earned by the lower income spouse must be in excess of the prescribed loan rate for this strategy to be effective and beneficial. For example, based on a 3 per cent prescribed rate, the lower income spouse would have to be earning a rate of return in excess of 3 per cent for this to be advantageous. Be sure to properly document the loan. Consider a promissory note signed by the borrower, detailing the date, amount, interest rate charged, terms of repayment and when interest is due.  Attribution Rules:  Income will not be attributed back to the lending spouse as long as the interest owed on the loan is paid by January 30th of each following year. If this payment is missed the loan will be invalid and full attribution occurs for that year and all future years.

Sharing CPP

Service Canada will allow you to split up to 50 per cent of your Canada Pension Plan benefits with your spouse. To determine if this income splitting opportunity would be beneficial for tax purposes, it is necessary to estimate both incomes for the current and future taxation years.

Household Expenses

An easy strategy to implement is to have the higher-income spouse pay all the family bills and expenses (including groceries, credit cards, mortgage, property taxes, insurance, etc.).  This allows the lower-income spouse to make investments with their capital.  The income on those investments is taxed to the lower-income spouses at a lower-rate.  The potential income in the hands of lower tax rates can be significant over time.

Annual Tax Bill

The higher-income spouse should pay any income tax liability owing from the lower income spouse.  In addition, the higher income spouse could pay any installments that are due.   The lower-income spouse should invest any income tax refunds, if applicable.

Third Party Loans

If the lower income spouse takes out an investment loan from a third party, the higher-income spouse should consider paying the interest portion of the loan.  The interest the higher-income spouse pays will be deducted on the lower-income spouse’s income tax return.

Swapping Assets

A less popular income splitting strategy is to swap non-income generating assets for income generating investments.  One example may be for couples that have joint ownership in their personal residence.  The lower income spouse could sell a portion (or all) of their interest in the residence to the higher income spouse.   The lower income spouse may invest the proceeds in income generating investments.  Another example, the lower-income spouse could exchange jewelry for income generating stocks or bonds of the same value from the higher-tax spouse.  This strategy could result in capital gains being realized.  Details of the transaction should be clearly documented.

Prior to implementing any income splitting strategy we recommend individuals meet with their professional advisors.

It’s never too early for income splitting

People may work for 40 or more years prior to collecting a pension.  It is during these years that couples acquire the wealth required for retirement.  Minimizing the amount of tax that you pay during this 40-year period is an important component to financial planning.  It is often said that it is never too late to start investing for the future.  It could also be said that it is never too early to start income splitting.

The Tax Fairness Plan announced by Ottawa relates strictly to specified pension income.  This is good news for many pensioners but primarily impacts individuals in their 60’s and older.  So, what about those first 40 years?  We encourage couples to take advantage of income splitting opportunities throughout their life.

In our last column we gave an overview of pension splitting.   Pension and income splitting are similar concepts with the same goal of shifting income from an individual in a high tax bracket to a family member in a lower tax bracket (or not taxed at all if the family member’s income is low enough).

The result for both should be a reduction in the amount of tax the household pays.  Income splitting is more encompassing and may include pension splitting and other strategies.  Income splitting is a term that may be used throughout your life at any age.  Income splitting strategies may extend to your entire family, such as spouse, children, parents.

Tax System

To understand income splitting fully one has to obtain a basic understanding of the Canadian tax system.  In Canada, tax rates increase in stages as taxable income increases.  A term that is often used is marginal tax rates.  This essentially means the amount of tax that you would have to pay to earn another dollar of income.   If one had to pay 26 cents in taxes to earn one additional dollar of regular income, then the marginal tax rate is 26 per cent.  This should not be confused with a person’s average tax rate.

The Rules

Prior to implementing any income splitting strategies it is important to understand the rules.   The rules, as outlined in the Income Tax Act, are designed to block your attempts to shift income from you to another person (usually your spouse or family member).  These are generally referred to as the “attribution rules”.

Attribution – Spouses

If you transfer or loan property either directly or indirectly (by means of a trust or any other means), for the benefit of your ‘spouse,’ any income or loss from the property and any capital gain or loss on the disposition of the property will be attributed back to you. This means that even though your spouse is receiving the income, the income must be reported on your tax return and will be taxed at your marginal tax rate. Effectively this leaves you and your spouse no better off from a tax perspective.

It should be noted that ‘spouse’ includes a common law partner, same sex couples who have been living together for at least one year and a person who subsequently becomes your spouse.

Attribution – Minor Children

Income on property transferred or loaned, directly or indirectly (by means of a trust or any other means), to a related minor child will be attributed back to you. This rule only applies if the child is under 18 at the end of the year. Unlike the rules for your spouse, it doesn’t apply to capital gains or losses on disposition of the property by the child. Transactions that open up to attribution are those in which a taxpayer and child are not dealing at arm’s length. Children, grandchildren, great-grandchildren, your spouse’s children and your child’s spouse are considered to be non-arms length, as are your brother, sister, brother-in-law, sister-in-law, and your niece or nephew.

Attribution – Adult Children

Funds/assets that are gifted to an adult child do not result in income attribution back to the parent.  Parents may have a tax consequence if they gift assets other than cash, as they will be deemed to have disposed of those assets.  It is also important to note that once the assets are gifted, they are the child’s to do with what they want.

Common Strategies

The above rules may give the appearance that it is very difficult to income split with family members.  Fortunately, with a little planning it is possible to divert income to your spouse and children and avoid the attribution rules.  Our next two columns will highlight some of these strategies.

Sharing pension may save tax dollars

Get used to the term pension splitting.  We’ve been hearing a lot lately about this part of the proposed Tax Fairness Plan unveiled lat October by federal Finance Minister Jim Flaherty, which is designed to save taxes by transferring pension income from the hands of one spouse or common-law partner in a higher marginal tax bracket to the hands of the other spouse in a lower tax bracket.

Pension income splitting is primarily referring to couples receiving pension income.  Many single individuals and widows have frowned upon the plan for this reason.

The main reason for splitting pension income is to reduce the household tax bill.  But there are other issues that go beyond tax savings.  Many social benefits are income tested and reducing income may assist the higher income spouse to obtain more benefits by splitting pension income.

A good example of this is the Old Age Security (OAS) claw-back – when income exceeds $64,511 pensioners must repay part of their OAS.   Transferring income over this threshold to the lower income spouse may assist the higher income spouse in receiving more OAS.

Another example relates to the pension income amount ($2,000 annually).  If the lower income spouse does not already have pension income then transferring pension income to the lower income spouse will enable both to qualify for the pension income amount.

Pension Splitting

Individuals may be permitted to allocate up to one-half of their pension income to their spouse or common-law partner.  It is important to define for splitting purposes what “pension income” is eligible.  The following is a list of eligible income that may be split (taken directly from the Department of Finance website:  www.fin.gc.ca):

  • Income in the form of a pension from a registered pension plan (RPP), regardless of the recipient’s age (i.e., a pension from an employer-sponsored defined benefit plan or defined contribution plan).
  • Income from a registered retirement savings plan (RRSP) annuity, a registered retirement income fund (RRIF), a LIF (a locked-in RRIF), or a deferred profit sharing plan (DPSP) annuity, if the recipient is 65 years of age or older.

Income that is ineligible includes

  • Old Age Security (OAS)
  • Guaranteed Income Supplement (GIS)
  • Canada Pension Plan (CPP) / Quebec Pension Plan
  • RRSP annuities, RRIFs, and DPSP annuities (if recipient is under age 65)
  • RRSP withdrawals
  • Income from retirement compensation arrangements (RCAs)

Noted above is that CPP income does not qualify as eligible pension income for splitting under the Tax Fairness Plan.  Existing rules already permit spouses and common-law partners to share CPP provided both are at least 60 years of age, collecting CPP and have submitted the appropriate forms.

Tax Calculator

The Department of Finance website also has a “Senior’s Tax Savings Calculator”.  It provides an estimate of the federal income tax savings but may not provide an estimate of the combined effect on taxes and all benefits.  The online calculator can be a useful tool for planning purposes but should never be substituted for professional advice from a qualified accountant.  There are many factors which should be considered before automatically splitting your income, including age, income levels, medical expenses, disability, current thresholds for Old Age Security, current thresholds for the Age Credit; whether the pension income amount ($2,000 annually) is currently being utilized by both spouses; and registered account balances

Some decisions to split pension income could have a negative outcome.  Using Mr. and Mrs. Irvine as an example, they earn $110,000 and $60,000 of pension income (primarily RRIF payments) respectively.  If the higher income spouse transfers $25,000 of pension income then both incomes will be $85,000.  Although they may save a little in taxes, the OAS clawback will likely exceed the tax savings.  We emphasize that it is important to look at all government benefits, credits, pension amounts and components that are unique to your tax situation.

April 2008

If the proposed income splitting is approved for 2007 then it is likely that you and your spouse will not need to make a decision until April 2008, when it is time to file your personal income tax returns for 2007.  At that time, the spouse with the highest income can allocate up to 50 per cent of their income to be taxed in the hands of the lower-earning spouse.  Your accountant will be able to prepare an analysis to determine the optimal amount of pension income to split with your spouse.  The result may be an increase in taxes payable for the lower income spouse and a decrease in the taxes payable for the higher income spouse.  One would only proceed with this if the combined tax liability is reduced.  If the legislation is passed and the tax liability is reduced, then both you and your spouse must jointly agree to the allocation by making an election in your 2007 tax return prior to April 2008.  This election would be required on an annual basis.


Locked-in plans require careful thought

Employees who retire, terminate their employment early, or find their pension plan being discontinued need to make some important decisions.  Some pension plans are being closed and employees have the “lump sum” or “annuity” option.  Other people are faced with a difficult choice, which we discussed in our last article.  Do you take a lump sum of money from the pension today, purchase an annuity, or wait to receive a monthly cheque at retirement?

The lump sum option allows the fully vested (owned) pension benefits to be transferred to a locked-in registered plan.  This article focuses on lump sum transfers to locked-in accounts.

So, what is a locked-in account?  This type of investment account is registered and is one where the plan issuer signs an agreement with your employer to “lock-in” your pension plan proceeds until retirement.  A lump sum from your pension plan is transferred into the registered locked-in investment account.  The age at which the funds may be released, and to what uses they may be put, vary with the pension legislation governing the plan.  Any amounts earned by the plan also become locked-in.

Withdrawals are generally not allowed from Locked-in Registered Savings Plans (LRSP) or Locked-In Retirement Accounts (LIRA), except in limited circumstances such as shortened life expectancy, small balance or financial hardship.  The governing legislation controls these funds, even though the employee can invest them as they wish (similar to an RRSP).  Some provinces have been changing their legislation with respect to locked-in accounts.

Governing Jurisdiction

Knowing the jurisdiction of your pension will assist your financial advisor in setting up the correct account.  In B.C., locked-in accounts are generally referred to as Locked-in Registered Savings Plans (LRSP).  In Alberta, Saskatchewan, Manitoba, Quebec, New Brunswick, Ontario, Newfoundland, and Nova Scotia these accounts are referred to as Locked-In Retirement Accounts (LIRA).

Company pension plans in Canada can be established and registered under either provincial or federal legislation. The legislation governing an individual’s funds must be established upon opening the locked-in plan, as this will determine what type of plan will be opened. The pension plan administrator or the financial institution transferring the funds should provide the information necessary to correctly identify the jurisdiction governing the funds.

Provincially Regulated Pension Plans

Most pension plans are established under provincial legislation. For all provinces and territories except Quebec, the province in which the client resides on the date they terminate employment determines the governing jurisdiction, which may in fact differ from the jurisdiction in which the company is registered.

For example, a person living in Ontario the day they terminate their employment will have their funds under Ontario jurisdiction. Even if this person moves to British Columbia and transfers their pension funds, the client must open a LIRA (the name for a locked-in plan for Ontario) and not an LRSP because the funds are still under Ontario jurisdiction.

Federally Regulated Pension Plans

For federally regulated pension plans, the person’s governing jurisdiction is Canada regardless of place of residence. This applies for crown corporations or companies under federal charter.  A person living in Alberta (which offers LIRAs) who has federally regulated funds will be required to open an LRSP, since federally regulated funds require LRSPs and not LIRAs.

Maturity Options

The earliest age in which you may transfer your LRSP or LIRA into an income account (LRIF or LIF) varies by province. The governing jurisdiction also dictates the minimum age when a client can transfer their locked-in funds.  Similar to an RRSP, locked-in accounts must be converted into an “income account” or a life annuity in the year individuals turn 69.   The 2007 Federal budget proposes to extend this conversion to when the taxpayer reaches the age of 71.


The minimum and maximum withdrawal amount will fluctuate from year to year and is based on the year-end value.  The year-to-year amount will vary depending on the amount of money you withdraw, the income your plan earned and any market fluctuations that may occur.  A LRIF/LIF is similar to a RRIF in that the holder is required to receive a minimum payment out of the plan each year.  The minimum payment levels are calculated using the same method used for RRIF payments.  Additionally, these accounts are subjected to a maximum withdrawal limit. The maximum amount is established by a formula, which takes into account a discount factor and the person’s age.

In the first year an LRIF/LIF is opened, there is no minimum withdrawal required; however there is still a maximum allowable payment. This maximum is pro-rated for the number of months, including the month of transfer into the plan that is remaining in the year.

Transfer Process

Moving from a Registered Pension Plan to a locked-in plan is usually straightforward.  The first step begins with opening a self-directed locked-in registered account.  The institution name and account number will be required to complete the forms provided by your employer.  Typical forms may include a cover letter with the estimated pension value, Canada Revenue Agency forms (i.e. T2151 for direct transfer and T2037 for purchase of annuity) and a locked-in agreement.  Your investment advisor should be able to assist you with completing these forms in conjunction with setting up the appropriate account.

Cash Transfer

Lump sum pension transfers to a locked-in account generally take two to four weeks and come in as cash.  During the transfer period we recommend that individuals meet with their advisor and begin planning their investment portfolio.  For many people a lump sum transfer from their registered pension plan represents the most significant portion of their retirement savings.

Before making a final decision we recommend that you speak with your professional advisors.


Looking at retirement options

Retiring employees and those who change careers or are displaced for various reasons are often faced with some difficult decisions, because how they deal with pension plans can have consequences for their retirement

Decisions can be easier if people understand their options clearly and the resources available.  Some may not have a choice with respect to their pension.  But for others the confusion begins when you’re given various options.  Many companies offer employees a choice between taking their pension in the form of a monthly payment or a single lump sum payment.   The following summarizes the two main types of pension plans – defined contribution plan and defined benefit plan (also known as money purchase).

Defined Contribution Plan

The contributions into this type of pension plan are established by formula or contract.  Many defined contribution plans require the employer and/or employee to contribute a percentage of an employee’s salary each month into the pension fund.  The employer does not make a promise with respect to the amount of retirement benefits.  The key point to take away is that the employee bears the risk of pension fund performance in a defined contribution plan.  We encourage individuals to take advantage of any pension matching your employer may offer.  With this type of plan employees are generally given a choice amongst different types of investments (i.e. conservative, balanced, aggressive).

Defined Benefit Plan

With a defined benefit plan, the employer is committed to providing a specified retirement benefit.  The benefit is established by a formula, which normally takes into account the employee’s years of service, average salary and some percentage amount (usually between one to two per cent). The key point to take away is that the employer bears the risk of pension fund performance.  Another key point is that the employee is able to calculate their benefit with more certainty then a defined contribution plan.

Monthly amount

Those with a defined benefit plan know with more certainty what their monthly payment amount will be, providing benefits for financial planning.  The end benefit is less known for people with defined contribution plans.  A key question to ask yourself:  “Is the pension your primary asset or main source to fund retirement?”  If the answer is yes, then we would encourage most people to take the monthly pension.  If your pension is not your primarily asset or you have multiple sources of income then leaving the fund and receiving a lump-sum may make sense.

Lump Sum

Choosing this option means that the monthly pension is forfeited.  For defined benefit plans, the intent of the lump sum option is to give the employee what is known as the present value (or commuted value) of the monthly pension amounts that would otherwise be received.  The calculation, which is usually made by an actuary, makes assumptions about life expectancy and inflation and uses a discount factor to determine what the lump sum equivalent should be. The lump sum amount is meant to represent the effect of receiving a lifetime worth of pension payments (from retirement to death) all at once.  It is important to note that individuals that leave the pension and receive a lump sum, may purchase an annuity with some or all of these funds.

Helping You Decide

The following are some factors to consider when deciding whether to stay with the pension, purchase an annuity or take the lump sum.

Retirement Planning:  Determining what you would like from your retirement may assist you in making the decision.

  • Is the pension your primary asset?
  • Would you lose sleep worrying about managing a lump sum?
  • Will the fixed monthly amount cover your monthly cash flow needs?
  • Are you concerned about outliving your savings?
  • Do you like the idea of managing your finances at retirement?
  • What other sources of income do you have to fund your retirement?

Investments:  Some people may want the freedom to choose their own investments while others may choose the hands off approach.

  • How are the funds currently being managed?
  • If you chose the lump sum would you manage the funds yourself or obtain assistance from a financial advisor?
  • How much risk are you willing to take with your investments?

Pension Benefits:  Many employers provide individuals that choose to stay with the pension a few other benefits that should be factored in.

  • Do you have a defined benefit plan or a defined contribution plan?
  • How long have you been a member of the pension plan and how is the pension formula calculated?
  • Is the monthly pension indexed?
  • Does the monthly pension option provide medical, dental or life insurance coverage?

Tax Consequences:  Major decisions relating to your pension should be discussed with your accountant.

  • Are there any immediate tax consequences?
  • Are any retiring allowances transferable to your RPP or RRSP?
  • How will the choice of options affect future income taxes?
  • Is it possible to split any income? (Note:  the Federal Finance Minister’s “Tax Fairness Plan” announced on October 31, 2006 outlines what income is eligible to be split)
  • Are you single, married or living common-law?
  • Does your pension provide a benefit to your surviving spouse (if applicable)?
  • Is leaving an estate important to you?
  • How close are you to retirement?
  • Are you in good or poor health?
  • Are you likely to get full value from a monthly pension?

Estate Planning:  Individuals interested in leaving an estate may feel the lump sum offers more advantages.

Life Expectancy:  This is perhaps the most important component to the decision making process.  Most people normally begin the decision process by doing a few calculations.  With every calculation people would have to make assumptions with respect to life expectancy.  If you were to live to an old age, significant value may be obtained by leaving your funds in a defined benefit plan or by purchasing an annuity with lump sum proceeds.

Spending the time to think about the above issues will allow you to have a more productive discussion with your professional advisors prior to making any decisions.  The choice people make with respect to their pension is one of the most important financial decisions they need to make.


When the dust settles on income trusts

Although a few weeks have passed since the news effecting the taxation of income trusts, time isn’t helping investors forget the Oct. 31 announcement.

The spectrum of comments in the media has ranged from general acceptance to outrage.  Two things are certain-  investors dislike negative surprises and the federal government is not going to reverse this announcement.

Investors who overweighted income trusts for a long period of time have profited handsomely.  One could surmise that it was good while it lasted.  The best way to combat volatility and uncertainty in the market is to diversify your portfolio.

The first step in diversifying your portfolio is to establish an Investment Policy Statement (IPS).  An IPS provides the framework for developing a disciplined investment approach.  A disciplined investment approach nearly always prevails in the long run.  Every individual has to obtain an understanding of the level of risk they are comfortable with.

An IPS also highlights the need to rebalance individual positions and asset classes periodically.  Determining an appropriate asset mix between cash, fixed income and equities is the most important decision investors need to make and a critical component of an IPS.   Any change in your personal situation or the taxation of investments should result in individuals reviewing their current IPS.

Illustration:  Mr. Patterson has the following asset mix – 5 per cent cash equivalents, 30 per cent fixed income and 65 per cent equities.  The cash equivalents component is invested in a money market fund.  Fixed income is comprised of Guaranteed Investment Certificates (GICs), bonds and treasury bills.  Mr. Patterson’s 65 per cent equity component is invested as follows:  common shares (25 per cent), preferred shares (10 per cent), mutual funds (10 per cent), exchange trade funds (10 per cent), and income trusts (10 per cent).  In the first week following the October 31 announcement, the income trust sector index declined on average approximately 14 per cent.  Some of Mr. Patterson’s exposure was to real estate income trusts which were not impacted.  There is no doubt that Mr. Patterson’s portfolio was negatively impacted from the income trust news.  Fortunately, other components of his investments, primarily his common shares, performed positively during this same period and his combined portfolio actually increased in value.

Concentration and Timing

Mr. Patterson’s portfolio mix described above provides one example of a diversified portfolio.  In many cases a diversified portfolio really shines when negative market events occur.  Individuals that chose to concentrate or overweight a portion of their portfolio within income trusts have been impacted the most, as were those people who purchased income trusts recently.  We encourage investors to understand the asset class weightings in their portfolio.  What component of your portfolio is comprised of income trusts?   Once determined, this should be compared to your overall investment plan.

Structured Products

As the income trust market has grown in popularity so too has structured products that pool these types of investments.  Many of these pooled products are structured as “closed end funds.” They trade on an exchange and may not be readily redeemable from the fund company.  As these structures trade on an exchange they may trade at a discount or premium to the actual Net Asset Value (NAV) of the underlying investments.  Some closed end funds have very low trading volumes and in the absence of individuals wanting to purchase, individuals entering market sell orders may receive a discounted value.   These structures often provide investors the ability to redeem at NAV at predetermined times.  We encourage investors to obtain an understanding of these dates and the various redemption privileges.

Active versus Passive

Individuals who have purchased structured products may want to determine whether the fund is actively managed or whether it has a passive structure.  Fees for actively managed funds are generally a little higher than passive structures.  Examples of a passive structure may be a basket of 100 of the largest income trusts, equally weighted.  Certain actively managed structures may provide a flexible mandate to change to other income asset class types, while others may be restricted to income funds only.  Investors should determine whether their funds hold income trusts and whether the mandate is flexible or not.  Investors holding active and passive income trust structures should assess these strategies in light of the recent news.

All Or None

For those investors that are holding individual income trusts the options are a little different.  The recent news highlights the need to hold quality investments.  Investors should clearly understand that the recent announcement does not wipe out the fact that many of these trusts are solid businesses that will continue to pay a stream of consistent income.  The tax efficiency will continue until 2011.  Often at times investors feel they have to make an all or none decision.  If you are undecided as to the best course of action then sometimes the middle road is the best option.  Selling half of a position that you are uncertain about will reduce your overall exposure but still provide you some income and hopefully the benefits if the trust market stabilizes or improves from its current state.

Stop Loss Orders

When uncertainty still exists regarding a specific investment many investors choose to put a stop-loss order to minimize further downside risk.  This type of order is used not only to reduce further losses but also to protect unrealized gains. This type of order is automatically triggered once the security’s price declines to the stated limit within the determined time and becomes a market sell order.  Investors should be cautious when entering stop orders on thinly traded positions.

Tax Consequences

Individuals that hold income trusts within a taxable account should assess their current tax situation.  Most individuals that have held these investments for a significant time may still have significant unrealized capital gains.  Selling prior to year-end may realize these gains and create a taxable capital gain.  Others that have recently purchased income trusts may have unrealized capital losses.  Tax loss selling is a strategy that can be used to offset capital gains from other investments.

What type of investment would you purchase today?  Some individuals may see value in those income trusts that have declined in value.  Others may choose preferred or common shares.  Solid research on blue chip equities has been a long-standing successful approach to equity investing.

Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors.

To trust or not to trust, that’s the question

The popularity of income trusts had been on the rise for years.  With monthly payouts and enhanced yields amid declining interest rates, many investors considered the trust attractive.  The Conservative government’s election promise to leave the taxation of income trusts alone further enhanced the popularity.

But everything changed on October 31 when Ottawa announced its “Fairness Plan,” a move to redesign the way income trusts are taxed that may investors felt was unfair.  Here’s a primer on the issue:

So what is an income trust?

An income trust is an equity investment that was designed to distribute cash flow generated from a business to unit-holders.  People requiring income from their investments were attracted to this structure as income is generally paid monthly or quarterly.  As a result of these distributions income trusts are often referred to as “flow-through” investments.  They typically fall under the following four categories:  1) royalty/energy trusts; 2) income/business trusts; 3) limited-partnerships; and 4) real estate income trusts.

Why were income trusts were created?

Investors who require income found trusts attractive as many paid out income on a monthly basis.  Over the past few years in an environment of declining interest rates, they provided an opportunity for risk tolerant investors to enhance their yield.  The majority of investment returns tend to be generated by the monthly/quarterly distribution stream while total returns may be increased or reduced by changes in the underlying unit price.  With an aging population there is no surprise that there was a strong demand for quality income trusts paying investment income.

What is the problem?

Income trusts are designed to be tax efficient.  Their tax effectiveness comes from the trust being able to distribute the pre-tax business income out to unit-holders.  Provided this income is distributed out to unit-holders then the trust has little to no tax to pay.  People receiving distributions from income trusts may or may not have been taxed immediately on these amounts.  Individuals holding these investments within registered plans, such as RRSP and RRIF accounts, were able to defer tax on this income even further.  The trust structure is considerably different than a corporate structure that must first pay tax on company profits prior to paying dividends to shareholders.  This is the primary problem that led to the recent announcement.  Ottawa may not have been too concerned in the past when trust conversions were primarily done by smaller businesses and taxation dollars were minimal.  With the recent announcements by BCE and Telus to convert to an income trust structure the Government was compelled to act in the interest of supporting their eroding tax base.  It is clear this became a greater issue when some of Canada’s largest companies began contemplating trust conversion.  As a result the Federal Government announced a new Tax Fairness Plan designed to balance the taxation of income trusts and corporations.

Tax Fairness Plan

The proposed Tax Fairness Plan has impacted income trust investors with the exception of those invested in real estate income trusts.  For the other three types of income trusts, profits within the trust will be taxed at corporate tax rates before distributions and distributions will subsequently be treated as dividend income.  These proposed changes are to take effect in the 2011 tax year for trusts that are currently publicly traded.  New income trusts that begin trading after October 31 are impacted immediately.

Political risk in Canada

Prior to investing in income trusts investors should have been aware that this recent announcement from Finance Minister James Flaherty was at least a possibility.  Just over a year ago, former Finance Minister Ralph Goodale spooked income trust investors by announcing that the Liberal Government was looking into the taxation of income trusts.

Ongoing risks

Prior to October 31, many investors may have felt the greatest risk to investing in income trusts is political uncertainty.  Another major risk is that distributions are not guaranteed.  When distribution payments are reduced, people’s income stream will be reduced and the market tends to respond negatively.  One common way to analyse income trusts is to look at the stability of distributions and the payout ratio (cash distributions dividend by available distributable income). Payout ratios greater than 100 per cent of available distributable income is generally an indicator that the trust may need to adjust the distribution level.  Volume of trading is also a concern with some income trusts.  Supply and demand has always driven the markets and some trusts are relatively illiquid.  Energy and resource related trusts are generally impacted either negatively or positively by changes in the price of the underlying commodity.  Changes in the level of interest rates have also had a significant effect on unit prices.  As with any equity investment, it is important to continually analyse the merits of the underlying business.

Coming Up

Many investors may be concluding that the existing trust market is likely to shrink considerably by 2011.  Our next column will provide a few options for investors to consider.  We will also provide an illustration of an investor with a diversified portfolio.

You’ll need a plan in order to live on investments

We recommend anyone requiring income from their investments to establish a plan.

An important component of that plan is to ensure income is transferred from a client’s investment account to their banking account.

Although investment firms still issue manual cheques, the number of transactions executed electronically is rising rapidly as investors are becoming more comfortable trusting the electronic transfer of funds from one account to another.  With electronic transfers, there is no risk of mail being lost and transactions are done in a timely manner.  When transfers are done on a scheduled basis they are referred to as a systematic withdrawal plan – often referred to as a SWIP.

A financial institution usually requests a void cheque from the investor’s banking account to obtain the institution, transit and account numbers.  SWIPS are set up to electronically transfer a predetermined amount from an investment to a banking account.  Understanding the income currently being generated from the investments, maturity dates, and liquidity of the portfolio are key components to look at when setting up an appropriate SWIP.

Investors have flexibility with respect to the amount of income they would like to receive and when they would like to receive it.  The following illustrations provide an overview of how SWIPs are often used.

Illustration 1:  Mr. Jackson requires a high level of income from his portfolio. He has requested we send him all of the income from his investment account on the first of every month.  Mr. Jackson has $200,000 invested generating approximately $12,000 per year in income.  We provided Mr. Jackson with an expected income report and noted that his monthly income ranges from $600 to $2,000; however, his average income is approximately $1,000 a month.  For the month of September he earned $740 investment income.  This amount will automatically be transferred to his investment account on the first of October.

Illustration 2:  Mrs. Reynolds has several investments that generate income.  She has a mixture of common shares, preferred shares, convertible debentures, and bonds.  Mrs. Reynolds would like to see her portfolio grow a little further before she begins pulling out all of the income generated.  She has decided to set up a SWIP that automatically transfers the investment income from the income funds to her bank account on the first of every month.  The income from the preferred shares and the bonds will stay in the investment account.  At some point in the future she may increase the SWIP to include all income.

Illustration 3:  Mrs. Walker has a cash flow need of approximately $4,000 per month.  Her sources of income are from CPP, OAS, and a small pension, all of which add up to approximately $2,400 per month.  How is Mrs. Walker going to fund the monthly shortfall of $1,600?  The most obvious place to look is her investments which are currently generating approximately $800 per month; short of the $1,600 she requires monthly expenses.  We explained to Mrs. James how a SWIP can be set up to transfer a flat dollar amount, such as $1,600, even if this amount exceeds the monthly income generated in the account.  We established a plan that allowed for certain investments to be partially or fully liquidated over time to ensure the monthly payments could be sustained during her lifetime.  This included factoring in projected income amounts and maturity dates of her investments.  With this type of SWIP more planning is required.