Everyone would like high returns and no risk. But having both is not realistic with all the economic news and market volatility.
It certainly makes it a challenge for people who are looking for the best option for investment savings and retirement cash flow. This is especially the case for people who have retired and would like to have income without working any longer.
I’ll use a recent discussion that we had with a business owner who sold her company for $1 million. She approached us to discuss her investment options with respect to the proceeds from the business. We provided her with the pros and cons of each:
Keep the funds in cash equivalents. The main advantage of this approach is that she would not risk losing any of the capital. Currently she could invest these funds in cash equivalents ranging from 1.3 to 1.5 per cent. Assuming a return of 1.4 per cent on the combined amount, her annual income would be $14,000. One con to this approach is that the funds she has to invest are all non-registered and investing it entirely in interest bearing investments means that the amount is fully taxable each year with no deferral ability. Another con is that if inflation is 3.1 per cent, then purchasing power is being lost each year if the after tax returns do not exceed the rate of inflation.
Invest in a five-year GIC ladder with $200,000 invested in each year (two different GIC issuers each year with $100,000 in each). We estimated this would result in annual income being approximately $21,040. One pro to this approach is that all investments would be Canadian Deposit Insurance Corporation (CDIC) and that total income would be approximately $7,040 a year higher than holding cash. A con to this approach is that GICs generate interest income that is fully taxable and have no deferral ability. Another con is that the before tax return of 2.10 per cent is still well below inflation.
Invest in corporate bonds and convertible debentures. The yields on these investments can fluctuate and is dependent on the level of risk assumed. Let’s assume the average yield is five per cent. The advantage of this approach is that corporate bonds and debentures can be sold at any time (at the current price) and can be purchased with longer term maturities. Another pro is that coupon rates are higher than GIC options. The con of this approach is that corporate bonds are not CDIC insured and debentures are unsecured. Similar to GICs, bonds and debentures generate interest income that is completely taxable. Corporate bonds and debentures have a market value that fluctuates (and are often traded), especially when interest rates change.
Invest in dividend paying preferred shares with an average yield of five per cent. A pro of this approach is that equities generate dividend income which is tax efficient. If the average yield is five per cent then the income would be approximately $50,000 annually. Dividend income is taxed less than one half of what interest income is taxed after factoring in the dividend tax credit. If times get difficult, companies would have to fully cut the dividend on the common shares prior to cutting the dividend on preferred shares. Preferred shares should see less volatility than common shares, especially if interest rates stay low for an extended period. Prior to investing in preferred shares it is important to understand the specific features of each type – they are not all the same. One risk is that many preferred shares today are perpetual, meaning that they have no maturity date. This means that they are very susceptible to changes in interest rates, especially if they do not have a reset feature. Many of the new issues of preferred shares have reset features every five years that should be fully understood before purchasing. It is important to note that some of these preferred shares could be reset at lower rates if interest rates continue to stay low. Nearly all preferred shares can be called at specified dates; this is a benefit to the issuer, not you the purchaser.
Invest in dividend paying common shares (referred to as blue chip equities) with an average yield of four per cent with growth potential. Similar to preferred shares above, many large companies also pay tax efficient dividend income. Unlike preferred shares, the dividend is not guaranteed and can fluctuate. In good times a company may periodically increase the dividend and in bad times you hope they maintain the current dividend. In some cases, companies are forced to cut or eliminate the dividend. In addition to the dividend not being certain, the value of the shares on common shares can fluctuate considerably. One benefit to investing in equities is that growth can be deferred until sold (realized) in the future. If the average yield is four per cent, then the income would be approximately $40,000 annually. The dividend component on a basket of common shares (i.e. four per cent) is normally lower than a basket of preferred shares (i.e. five per cent). Common shares also participate in the success and failure of the company’s operations. When purchasing common shares it is important to reduce risk by monitoring position size and sector exposure.
There is no easy option today when it comes to picking the right investments. The best investment option really depends on the individual’s risk tolerance, time horizon, and other sources of income. Generally looking at a long term balanced approach is the best. A balanced approach refers to having a combination of all or some of the above.