Nov 1, 2009
As the baby boomer generation has aged, the ever-shifting forces of demographics have begun to push the financial industry from one focused on wealth building and accumulation to one that will concentrate on distribution and income generation. The signs of this are inescapable to anyone who has been paying attention.
While 10 years ago, the primary focus of manufacturer marketing was on returns, today those same manufacturers are focusing marketing on distribution yields, income guarantees and innovations, which provide these features.
Arguably, for the most innovative of these new breeds of income and distribution focused products to work, they would have to be Guaranteed Minimum Withdrawal Benefit (GMWB) segregated funds, which guarantee a minimum income of 5% of the original deposit value.
Analysis of these products is typically focused on gross yields, but little or nothing has been written about the net after tax yields of these funds. This may largely be due to the fact that they’re geared to attract assets that will be used to finance investor’s retirement, and therefore have primarily attracted registered assets. That being the case, there’s little need to focus on taxation, since all income distributed from a registered account is taxed as income regardless of its method of investment. But it begs the question: How would these funds fare in a non-registered portfolio?
In a non-registered portfolio, tax plays a very large factor. After all, each type of income (interest, dividends and capital gains) attracts different rates of taxation, which determines the portfolio after tax yield. Therefore, the type of income has an impact on the overall taxation, as well as the net after tax yield.
So, how does the net yield from a GMWB portfolio stack up to its alternatives: a portfolio of individual stocks and bonds, mutual funds, T-SWPs, corporate class funds, corporate class T-SWPs, GICs and annuities. Each product or investment option has its own costs and benefits; therefore it’s impossible to say which option is best as each conviction is dependent on each income-planning scenario.
That said, we could easily compare those options in terms of one specific cost: the initial investment required to match the net after-tax yield provided by these guaranteed funds.
The analysis assumes the following variables:
Client age is 65;
Initial investment is $500,000;
Portfolio composition is 65% fixed income and 35% equity;
Interest yield is 4%;
Dividend yield is 2.5%;
Equity total return is 9%;
Turnover rate is 25%; and
Marginal tax rate is 40%.
For the sake of simplicity, the example ignores a few variables. While important in making recommendations for clients, they are each in themselves another debate all together. These variables include:
Volatility – assume an average annual straight line return and ignore the effects of negative dollar cost averaging;
Level payments – assume payments stay fixed and do not adjust upwards; and
Fee disparities – each option has its own associated fees, so the differences between the fees have not been factored in.
The GMWB Scenario
Given these variables, the net yield on the portfolio ends up being 5.75%, resulting in more than enough income to meet the 5% distribution. The type of income making up the 5% distribution breaks down like this:
Interest is 2.6%;
Dividends are 0.88%; and
Capital gains are 1.52%.
Once we apply the tax rates to each component of the distribution, we’re left with an after-tax return of 3.54%. Going forward, the 3.54% ($17,700) is the income yield target we will try to reach with the alternative investments.
Regular Investment Portfolio
Whether accomplished by way of individual holdings or a mutual fund portfolio, a regular investment account is the most basic alternative to GMWBs.
But an analysis is not needed to compare this alternative as there’s no difference in the taxation of individual investment portfolios, mutual fund portfolios or GMWBs. Therefore, the initial investment of $500,000 needed to match the return and yield of the GMWB investment remains static.
T-SWPs, Corporate Class and Corporate Class T-SWPs
T-SWPs are a mutual fund product that yields a targeted distribution to the investor. What’s special about this product is the bulk of the distribution is deemed to be return of capital (ROC), therefore making it non-taxable.
Once the cumulative ROC distributions erode the adjusted cost base, all future distributions are considered taxable. Typically, these funds will target a payout of 5% or 8%. For this example, only take the 5% distribution funds into consideration, since 8% is not sustainable.
Now, these funds have been around for some time, but recently a new innovation has come about, Corporate Class T-SWPs.
Corporate class T-SWP funds are a form of mutual fund investments that carry several tax benefits. They include:
Tax deferral – These funds commonly make no distributions until time of sale, resulting in potentially no taxation until time of sale;
Income conversion – At the time of sale, all gains are taxed as capital gains, even if they were earned through bond holdings, thus reducing the investor’s tax rate; and
Tax free switching – Switches between funds within the same fund family will not result in taxation.
The combination of corporate-class funds and T-SWPs has an additional benefit: 100% of the scheduled distributions are considered return of capital and are therefore non-taxable until the original ACB has been eaten away.
In light of this feature, the question remains: Is there any benefit to using T-SWPs or corporate class funds over a corporate class T-SWP? Personally, I can’t think of one reason why someone wouldn’t want to defer tax and convert the eventual taxation to capital gains.
It should be noted this analysis only considers corporate class T-SWPs. Assuming the advisor deploys a 5% corporate class T-SWP fund, the client would have to invest $354,000 in order to yield the same after-tax income of $17,700. However, this would only be the case for the 20 years it takes to eat up the ACB. At that point, the investor would be 85 years old. If the investor is still alive at that time, additional funds would have to be used to compensate for the loss of cash flow due to taxation.
GIC’s are the traditional haven of risk adverse investors. In a scenario where only interest is utilized, in order to achieve our desired after-tax income of $17,700 the GIC portfolio would have to generate $29,500 pre-tax. Assuming a five-year average GIC rate of 5%, this would require an initial investment of $590,000.
Unlike the other options, single premium immediate annuities offer no liquidity, or reversal of investment decision. And they’re gender specific. The tradeoff? The investor gains an income stream he or she can never outlive. Only GMWBs can make this same claim. Plus, there is an additional benefit. With prescribed annuities, part of the cash flow is deemed to be return of capital and, therefore non-taxable. In this scenario, it would only cost an investor $252,000 for a male and $278,800 for a woman to achieve the needed income level.
After completing the analysis, we have learned the after-tax yield delivered by a GMWB:
Is equal to that which can be delivered by a portfolio of individual stocks and bonds or that of a mutual fund portfolio;
Can be delivered by a corporate class T-SWP fund with an investment of 29% less than the GMWB portfolio requires;
Would require a GIC portfolio with an investment of 18% more than the GMWB investment; and
Can be generated by single premium immediate annuities for 44%-to-50% less than the GMWB portfolio, depending on gender.
Advisors have more options than ever when it comes to delivering income to their clients, but each product solution has its costs and benefits. In the end, there is no one size fits all solution and some come at a very large premium compared to others.
When designing an income strategy for clients, each advisor must balance the various costs and benefits with the client’s needs and tolerances.