How to generate a tax-efficient income

In the early 1980s, financial planners often had a general rule of thumb that the amount you had in low risk investments, such as bonds and guaranteed investment certificates (GICs), should equal your age.

For example, John Smith who had retired in 1981 at age 60, may have been advised to have 60 per cent in fixed income at that time.  Let’s also assume that John Smith had $500,000 when he retired.  In 1981 interest rates on GICs and other low risk investments, including annuities, would often yield 15 per cent or more.  If John had put all his money in fixed income at 15 per cent then the annual income would have $75,000 a year.

John had a son named Paul who is 65 today.  Paul is struggling with the fact that guaranteed investments today do not have the same yields that his father had.  Paul has $1 million in the bank but is looking at yields of just over one per cent to keep the money in the bank or up to three per cent if he commits to a five year term.   A return of between $10,000 and $30,000 is what Paul is looking at today if he wants a guarantee on his investments.

Many investors like term deposits and GIC for the simplicity and safety.  Unfortunately, investors pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments; their real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s illustrate using Paul above who has $1,000,000 in non-registered funds.  One option he has is to hold $200,000 in five different GICs ranging from one year to five years (called laddering). We will assume that the basket of GICs have an average yield of 2.5 per cent.  We will also assume that Paul has a marginal tax rate of 30 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $1,000,000 x 2.5 Per Cent = $25,000

Taxes at 30 Per Cent                               =   (7,500)

Net Return                                               =  $ 17,500

A net return of $17,500, or 1.75 per cent, is what is ending up in Paul’s pocket.  With inflation greater than 1.75 per cent then the “real return” will be negative.  In other words the amount of money in Paul’s pocket will buy less as time goes on.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

The Bank of Canada website has an excellent calculator for investors who want to computer their own numbers.

Most economists are expecting interest rates to remain low for a long time.  The challenge Paul faces today is likely to extend throughout his early retirement.  Paul approached us to talk about an alternative to the net return of 1.75 per cent – this is before inflation.

The first thing we reviewed with Paul is that there is a cost to requiring 100 per cent certainty in this environment.  In talking to Paul about alternatives today we suggested that he consider diversifying his investments to include various types of investments including GICs, preferred shares, corporate bonds, convertible debentures, dividend paying common shares.

In mapping out some ideas for Paul we highlighted that preferred and common shares pay dividend income that is tax efficient.  We did some calculations to see what ends up in Paul’s pocket, after tax, is nearly double what the interest income would earn.  More importantly is that he is likely to earn more than the rate of inflation.

We spent a fair bit of time talking about inflation and what types of investments will protect him from this risk throughout his retirement.  Dividend paying common shares should keep better pace with inflation then low yielding interest bearing investments.  The dividend paying common share approach looks even better when you look at the after tax component noted above.

The challenge with the common share approach is dealing with the volatility of the stock market.   We spent a significant amount of time talking about his retirement.  We used a life expectancy of age 90, meaning 25 years in retirement.   During this period, Paul would expect to see various market cycles.  Rallies and corrections will occur during the bear and bull markets over the next 25 years.  The key point to focus on is income flow and longer term returns on the portion allocated to equities.

Despite the low interest rates today we still recommend that Paul have some fixed income.  This is the capital preservation side of his account that also generates income and protects his capital from a significant correction.  If rates rise in the future this will likely be the result of the economy moving in the right direction.  Assuming interest rates and equities rise in the early part of Paul’s retirement then he could begin reducing his equity exposure and gradually move the proceeds into fixed income.