As baby boomers retire, more focus on investment income is needed. The objective is simple: “don't let me run out of money.” There is no substitute for spending less, but this is an unsatisfactory answer for most. In this example, we use the popular "rule of thumb" of 4% annual spending. In a soon-to-be-published paper in the Rotman International Journal of Pension Management (April 2013), we study this challenge in greater detail using different investment and spending strategies. Here, we offer three observations that may be useful to retiring individuals and their advisors.

  1. Good news! A 4% per annum drawdown rate is quite sustainable. This rule-of-thumb withdrawal rate is from the famous "Trinity Study" by Cooley, Hubbard and Walz (1998), professors at Trinity University in Texas. The authors showed that a mix of 50% equities and 50% bonds coupled with a 4% withdrawal rate in the first year, with the amount adjusted for inflation in subsequent years, resulted in a high probability of the retirement portfolio lasting over a 30-year time horizon. Our research confirms this finding. For a 65-year-old, the probability of running out of money, spending 4% of capital annually, is only 2.7% for a 50% equity/50% bond portfolio. On the other hand, 4% represents only $10,000 per annum in this example with a $250,000 portfolio; not much for those without additional sources of income. A dynamic asset allocation strategy that extends capital for more aggressive drawdown rates is possible (upcoming Rotman paper).
  2. Annuities reduce liquidity, diminish the opportunity to leave a bequest and are expensive. Unforeseen expenses from healthcare to divorce to adult children "failing to launch" explain why these insurance vehicles are not popular. Although annuities address longevity risk, inflation protection is often not included. Heightened credit risk in recent years has not encouraged consumer confidence in the insurance industry.
  3. Sequence risk, or the potential impact that the sequence of returns can have on a portfolio in the presence of withdrawals, has been explored by many researchers. Moshe Milevsky, in his book, The Calculus of Retirement Income: Financial Models on Pension Annuities and Life Insurance" (2006), points out that the first seven years of retirement affect the probability of ruin the most. Our research suggests that initiating portfolios with a more conservative mix early in the post-retirement period, followed by a gradual ramping up of risk during the first five to seven years after retirement commences, is a way of mitigating sequence risk.

Income portfolios in a low interest rate environment are true tests for the investor and her advisor. On one hand, there is a need to generate income but the threat of higher interest rates threatens the principle of fixed income instruments in a portfolio. We have used dividend income as the primary offset in each of the three investment strategies below.

Caution, holding non-Canadian dividend paying ETFs can have a significant withholding tax cost. Even if they are held in an RRSP account, there is no way to recoup these taxes. We chose ETFs that hold outright securities rather than ETFs of ETFs to minimize this problem. Although the U.S. Internal Revenue Service exemption has been extended for 2013, we focused on ETFs that avoid the problem to minimize rebalancing costs in case the situation changes in 2014.

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Private real estate can be an excellent holding in retirement for all the reasons stated. The Canadian private REIT market is a tricky place for the uninitiated investor however. Unlike the U.S. REIT market that is dominated by institutional investors who keep operators to a more strict agenda, Canadian REITs primarily target retail investors who may not be as sophisticated or demanding. The consequence is smaller size, higher costs external management, layered fees, and suboptimal financing structures. Above average scrutiny required.

Friday, February 15 @ 5:57 pm //////


When you are looking at an investment, ask yourself at least five important questions. Will the investment keep up with inflation? Will the investment avoid or at least minimize investment risk? Will the investment protect against taxes? What kind of return potential does this investment provide? And do I need special skills or knowledge?
Does a Private Real Estate Investment Trust meet the above criteria?
1. Real estate is an excellent hedge against long term inflation as rents tend to move along with prices in the economy.
2. The most conservative REITs invest only in apartments. They are considered to be the least volatile mostly because they do not suffer from “anchor tenant risk”, namely that no individual tenant leaving an apartment building can materially affect rents in the same way that a big box chain could in, say, a shopping centre REIT. Distributions from REITs can be very tax efficient; they offer a “return of capital” model, the product of CRA-approved accelerated depreciation on leveraged properties. In many cases, distributions are tax-deferred for many years.
3. Because REITs can depreciate (as capital cost allowance) their buildings each year, distributions are often tax “deferred” and your income may not be taxable until such time as you sell your units, providing you with good tax deferred cash flow while you remain invested.
4. Historically, Canadian private REITs have provided total returns (income plus capital growth) of between 7-10% per annum, and typically pay distributions monthly.
5. A REIT takes care of: actively keep searching the market for the right properties to buy, in the right locations, in the right cities, know how much to pay, what to spend money on, set capital and operating budgets, manage cash flow, manage utility price risk, manage tenant relations, survey market rents to determine what to charge to get the most income out of the property, research the newest technologies to save money, look for new revenue sources (like selling carbon credits, energy co-generation, laundry and parking income), keep an eye on financing opportunities and risks, put contracts out to tender, ensure that contractors do a quality job, maintain the buildings, keep employees trained and happy, keep up with regulatory requirements, deal with evictions and collections, ensure that you meet all property standards, health and fire codes…the list goes on; making an investment in real estate as passive as it could get.
Private Real Estate Investment Trusts and Real Estate Limited Partnerships should be considered in everyone’s portfolio especially those of retirees.

Wednesday, February 6 @ 12:45 pm //////

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