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By Jonathan Chevreau
National Post
"Advisor Post"
Monday, December 04, 2006 |
The uncertainty over income trusts has financial advisors scrambling to find alternatives for yield-hungry investors, many of them seniors.
Adrian Mastracci, fee-only portfolio manager at KCM Wealth Management in Vancouver, says, "I list REITs, high-quality corporate bonds, foreign bonds and various mortgage products as possible yield-enhancers."
They're not easy to find, says Nate Mechanic, who says there's no rush for clients to get out of trusts, since the damage has been done.
The short answer for Mechanic and other advisors is that clients will have to return to the traditional total-return approach. This amounts to a normal diversified portfolio of stocks, bonds and preferred shares.
However, "bonds are not the friendliest place for yield," Mechanic says. An investment-grade bond might yield around 4.5% today. "There's too much money chasing bonds and the spread between corporates and governments is skinny."
Adrian Mastracci, president of Vancouver's KCM Wealth Management Inc., lists REITs, high-quality corporate bonds, foreign bonds and various mortgage products as possible yield-enhancers.
Mechanic gives the nod to Canadian and foreign dividend mutual funds focused on high-quality stocks committed to growing their dividends.
So does Fred Kirby, a B.C.-based certified financial planner. He notes: "Established dividend-paying stocks purchased at reasonable prices do the best for investors in the long run when purchased at reasonable valuations."
Since Oct. 31, investors have rediscovered high-yielding stocks such as those of the banks. Dividends became more attractive in non-registered plans after Ottawa sweetened the tax credit a year ago.
Ironically, given the now defunct foreign-content limit, Canadians are still swayed by tax considerations to hold domestic securities. But instead of being forced to do so in registered plans, they have a tax incentive to overweigh Canadian stocks in taxable plans. The temptation is comparable to income trust investors swayed by yield.
Enthusiasts view income trusts as a benign hybrid of stocks and bonds, but the reality is most are high-yielding equities, often small- or mid-cap issues in volatile sectors such as energy.
Patrick McKeough was not keen on income trusts in the first place. Investors were already taking on equity risks, and low-grade ones at that. Their choice now is to accept lower yields on traditional bonds or seek higher returns through stocks, primarily in North America.
Warren Baldwin also counsels the traditional total-return approach. Typical retirees have a 60% stocks and 40% bonds mix, with equities split between Canada, the United States and the rest of the world.
Baldwin says nothing provides quite what income trusts supplied. "Those were a unique vehicle. People have to get used to the fact a more balanced portfolio gives them a more modest return."
Portfolios seldom had many trusts. Done properly, a total-return approach generates comparable income. Baldwin says a 7% blended return can be achieved this way, assuming 4% from bonds and 10% from equities. For those in the top tax bracket, 7% is equivalent to a 9% income trust return because of favourable tax treatment on capital gains and dividends.
Baldwin estimates that after tax, income trusts yield 4.8% on average (not adjusting for return of capital and other complications). That is almost the same as the 4.6% after-tax return of the total-return approach.
The income trust imbroglio occurred weeks after Manulife Investments unveiled Income Plus. Nigel Kettle is enthusiastic about this "finsurance" product. He is giving clients a one-pager on how it works for a 60-year-old with $100,000 allocated 80% to equity funds and 20% to fixed income. At worst, this client gets his capital returned at $5,000 (5%) a year for the next 20 years, no matter how stocks fare. Every three years, capital gains can be locked in. So if you lock in a $120,000 value, the portfolio is reset and payments rise to $6,000 a year for the next 20 years. The maximum number of resets is 10, for a period of 30 years. IncomePlus lets you create four accounts, so investments can be spread over three years, permitting a third of the total portfolio to be reset and locked in each year.
Extra fees are layered on top of the underlying fund management expense ratios but some retired clients may view this as reasonable for the peace of mind.
However, few other advisors consulted for this piece are sold on it. McKeough says "adding comfort costs money." Martin Kosterman of Oakville, Ont.-based Fiscal Agents says such products entail giving up some upside as well as paying the cost of protection on the downside. Even so, he views some insurance products -- notably prescribed annuities -- as one possible part of the solution.
Clay Gillespie prefers a version of "asset dedication." Given low payouts from bonds or guaranteed income certificates, Gillespie says retirees will need equities to provide desired income.
That means stocks, whether held individually or as equity mutual funds or exchange-traded funds.
Gillespie starts with an investment policy statement to capture client goals and risk tolerance. A retirement illustration is created, showing income from employer pensions or government. He adds five or 10 years to client life expectancy.
Next is the investment portfolio, which also takes a total-return approach. It's important not to withdraw funds from an asset class declining in value. He recommends annual withdrawal rates not exceed 5.5%. (Kirby says this is on the high side.)
Gillespie then invests one full year's worth of income in a money market account, a second year's worth in a one-year bond or GIC and a third year's worth in a two-year bond or GIC. Bond or mortgage funds can't be used used because their values can fall when rates rise.
The rest is invested in growth vehicles. The authors of the book Asset Dedication suggest five years of fixed income investments. Gillespie says he "camouflages it" by including balanced funds or equivalents as part of the growth portfolio.
With this strategy, clients are not forced to take income from investments falling in value. This would only occur if a bear market lasts more than three years. On the flip side, when the market generates strong returns, some growth positions are liquidated for income. Additional funds are transferred from the growth account to rebalance the fixed income part of the portfolio.
"The whole rationale for this strategy is to increase the life span of your portfolio," Gillespie concludes.
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