Weighing the benefits of managed accounts

A managed account is a broad term that has been used in the financial services industry to describe a certain type of investment account where the portfolio manager has the discretion to make changes to your portfolio without verbal confirmation.

There are different names and types of managed accounts which may be confusing for investors when looking at options between financial firms.

To assist you in understanding the basics of managed accounts we will divide the broad category into two subcategories: individual managed accounts and group managed accounts.

Both individually managed and group managed are fee-based type accounts, as opposed to transactional accounts where commissions are charged on activity. Individually managed accounts must be fee-based and generally have a minimum asset balance of $250,000.

Before we get into the differences between individual and group accounts we should also note that strict regulatory and education requirements are necessary for individuals in the financial service industry to be able to offer managed accounts. The designation “Portfolio Manager” is typically awarded to individuals who are able to open managed accounts. Financial firms may also stipulate certain criteria prior to allowing their employees to provide discretionary advice or portfolio management services. Examples of additional criteria that may be required by financial institutions include a clean compliance record, minimum amount of assets being managed, good character, and significant experience in the industry.

For purposes of this article, the term “Advisor” is different from “Portfolio Manager.” A portfolio manager may have the ability to offer individually managed accounts on a discretionary basis, whereas an advisor does not. An advisor must obtain verbal authorization for each trade that they are recommending. A client must provide approval by signing the appropriate forms in order for the portfolio manager to manage their accounts on a discretionary basis.

Above we noted the two broad types of managed accounts – individual and group. A portfolio manager is able to offer both individual and group accounts on a discretionary basis. The individual account is a customized portfolio where the portfolio manager is selecting the investments. Although an advisor is not able to offer individually managed accounts, they can offer group managed accounts through a third party. A simple example of this is a mutual fund which is run by a portfolio manager. A more complex example of this is the various wrap or customised managed accounts offered by third party managers. An advisor can recommend to their clients a third party group managed account.

The role of an advisor in a group managed account option is to pick the best third party manager and to assist you with your asset allocation. When looking at this option you must weigh the associated costs over other alternatives. The group managed account has set fees. With individually managed accounts the portfolio manager has the ability to both customize the portfolio and the fee structure.

Trust is an essential component that must exist in your relationship to grant a portfolio manager the discretion to manage your accounts.  Prior to any trades, the portfolio manager and investor create an Investment Policy Statement (IPS) to set the trade parameters for the investments. The IPS establishes an optimal asset mix and ranges to ensure that cash, fixed income, and equities are suitable for the investors risk tolerance and investment objectives.

Quicker Reaction Time: Having a managed account allows the portfolio manager to react quickly to market changes. If there is positive or negative news regarding a company then the portfolio manager can move clients in or out of a stock without having to contact each client individually. With markets being volatile this can help with reaction time. For an advisor to execute the movement in or out of a stock, it would involve contacting each client and obtaining verbal confirmation.

Strategic Adjustments: If a portfolio manager has numerous clients and would like to raise five per cent cash, this can be done very quickly with an individually managed account. It is more difficult for an advisor to do this quickly as verbal phone confirmation is required for each account in order to raise cash. Even with a group managed account, the advisor would have to contact each client to change the asset mix weighting.

Rebalancing Holdings: With managed accounts, clients have unlimited trades. This is important as it allows a portfolio manager to increase or decrease a holding without being concerned about going over a certain trade count. As an example, we will use a stock that has increased by 30 per cent since the original purchase date. Trimming the position by selling 30 per cent is easy for a portfolio manager as a single block trade can be done. This block trade is then allocated to each household at the same price. If an advisor wanted to do this same transaction, it would likely take a couple of days and over this period each client would have a different share price depending when the verbal confirmation was obtained.

Extended Holidays: If you are travelling around the world or going on a two month cruise then you probably want someone keeping an active eye on your investments. An advisor is not able to make changes without first verbally confirming the details of those trades with you. A portfolio manager is able to make adjustments within the IPS parameters, provided you have a managed account set up before your departure.

Not Accessible: If you work in a remote area (i.e. mining or oil and gas industry) then chances are you may be out of cell phone reach from time to time. In other situations your profession does not easily allow you to answer phone calls (i.e. a surgeon in an operating room). In other cases, a lack of interest may result in you not wishing to be involved. A managed account may be the right option for clients that are frequently difficult to reach to ensure opportunities are not missed – in these situations the portfolio manager can proactively react to changing market conditions.

If you completely trust your advisor and agree with the trades recommended in the past then a managed account may be right for you. Managed accounts greatly simplify the investing process for both you and the portfolio manager.

Many factors come into the calculation equation when determining when to convert your Registered Retirements “Savings” Account (RRSP) into a Registered Retirement “Income” Account.  An RRSP is used as a way for many Canadians to save for retirement and is essential for individuals without an incorporated business or a registered pension plan.

After all the years of saving, many people are still somewhat uncertain of when to begin drawing the savings out as regular income through a RRIF account.  Maximum deferral to age 72 can result in a shock in the rise in taxable income once RRIF minimum withdrawals begins.

To illustrate we will use Martin Hitchon, who turned 71 this year and is required to convert his RRSP account to a RRIF account before December 31 but is not required to take a payment in the first year.  Martin currently has $500,000 in his RRSP that will be rolled into his RRIF account.  Next year Martin is required to withdraw 7.48 per cent of the value of his account on December 31 of the year he turned 71.  The required annual minimum payment is stated as a percentage of the previous year end value.  These percentages increase slightly until age 94 where the maximum rate of 20 per cent is reached.  Assuming Martin’s portfolio is at $500,000 at the end of the year, he will have a minimum payment equal to $37,400 that will be considered taxable.

The perfect RRSP strategy is to contribute in high income and upper tax bracket years, and to pull funds out when you’re in a lower tax bracket.  The sudden increase in income with RRIF minimums left until age 72 may result in many people being in a higher tax bracket.  Many people may be wondering if waiting until age 72 is the best decision, especially knowing that this income will be on top of CPP, OAS, and other income.   The purpose of a financial plan when you’re younger is to map out the required savings to reach your shorter term goals and projected retirement needs.  The plan may also include a protection strategy for your family.  As you approach retirement the focus often shifts to understanding where cash flows will come from and which pools of capital you should access first.

Our clients who have taxable income over $125,000 annually are typically advised to wait until age 71 to convert and to take the first payment at the end of the year in which they turn 72.  In setting up the RRIF for high income couples we elect to use the younger spouses age to obtain maximum deferral.   Once clients are in the top marginal tax bracket (43.7 per cent in BC) the best strategy is to defer the tax liability by continuing to tax shelter within the registered account.

When income is expected to be below $125,000 then the decision on whether to convert your RRSP early to a RRIF is not straight forward.  Once you convert to a RRIF you are then obligated to begin taking income out for all future years.  It is possible to convert from a RRIF back to an RRSP prior to age 71 if your circumstances change.  The following are the key items to discuss when we are talking with clients:

Watching Thresholds – The Guaranteed Income Supplement (GIS) and the allowances are not based on net worth.  Many high net worth individuals have equity in real estate, corporations, and trusts that result in personal net income being low.  The GIS and the allowance stop being paid at $39,600 and $30,576, respectively.  Pulling funds out of an RRIF early could result in you losing these benefits.  Pensioners with an individual net income above $69,562 will have a portion of their Old Age Security payments clawed back if RRIF income is taken early.  The full OAS pension will have to be repaid if net income is $112,966 or above.   Projecting your income in the future will help in mapping out a strategy factoring in these thresholds.

Ratio of Non-Registered to Registered – Ideally as you enter retirement you have savings in both non-registered and registered accounts.  The non-registered savings are already after tax dollars and can be accessed with less tax consequences then registered funds.  This is especially important as you factor in potential lump sum needs in the future (i.e. new car, roof repair).  The greater the funds you already have in non-registered funds the easier it is to manage emergencies and to smooth out your income during retirement while at the same time fulfilling your cash flow needs.  If you have limited non-registered funds then earlier withdrawals may make sense.

Liquid Assets – High net worth is often locked up in real estate or assets that are not easily converted into cash.  Often at times the number one deciding factor in whether to pull funds out of a RRIF early is a result of cash flow needs and access to liquid funds.

Tax Free Savings Account (TFSA) – People without TFSA or non-registered accounts should consider pulling $5,000 out of their registered accounts annually to fund the Tax Free Savings Account.  Growth in a TFSA can be tax sheltered while at the same time building up a reserve of funds for you to access if an emergency arises.

Pension Income Amount – Beginning at age 65, investors without any other qualifying pension income are able to effectively withdrawal $2,000 annually from their RRIF account tax free.  This is because the income would be offset by what is referred to as the pension income amount.  Couples can withdrawal $4,000 annually with no taxes.

Pension Splitting – With the introduction of pension splitting the strategy for many couples has changed.  Up to fifty per cent of eligible pension income can be shifted from the high income spouse to the lower income spouse.  RRIF withdrawals beginning at age 65 qualifies as eligible pension income.

Couples – RRIF accounts are 100 per cent taxable upon death.   Nearly half of a RRIF balance of a single individual could go to taxes.   Couples have significant less risk of paying a large tax bill as they have the ability to elect a tax free roll-over a RRIF to the surviving spouse provided their spouse is named as a beneficiary.  This becomes trickier with second/third marriages with children from previous relationships/marriages.  The tax on the RRIF would be deferred when a spouse is named until the second passing and would likely be depleted slowly over time at more favourable marginal tax rates.

Other Estate Factors – Various other estate factors can result in different strategies for your RRIF account.  Some people may leave a RRIF account to a charity which would offset the large tax liability.   Insurance (i.e. joint last to die) is often a useful tool to cover the tax liability for a RRIF’s deemed disposition upon death.  Understanding your own health and family genetics is a factor that should be considered in the timing of when to withdrawal funds from your RRIF.