As investors approach retirement, many will ask their advisors whether it’s time to change strategies to focus on dividends and other income-generating investments. It’s easy to see why they feel compelled to switch gears once they are no longer in the accumulation stage. But problems can arise when retirees base their investment decisions primarily on yield rather than looking at the big picture. Here are three reasons to focus on a retiree’s total return rather than current income.
You’re probably going to spend capital anyway. Let’s start by challenging the whole idea that retirees can live off the income from their investments. In the strictest sense, this means deriving all of one’s cash flow needs from dividends and interest, without having to draw down capital. That may have been possible when bonds were yielding 6%, but most Canadians today will never have this luxury.
Unless you’re taking excessive risk, a balanced portfolio these days is not likely to yield more than 3%. (The yield on 10-year government bonds and the dividend yield on the S&P/TSX Composite are both around 2.5%, while the yield on the S&P 500 is less than 2%.) That means you would need $1 million to generate a modest $30,000 in annual income—and if it’s coming from an RRIF, that amount would be fully taxable.
Most Canadians don’t have seven-figure portfolios. So chances are their retirement income strategy is going to involve some combination of dividends, interest and realized capital gains anyway. If that’s the case, choosing investments based primarily on yield isn’t necessary.
Dividends are not necessarily tax-friendly. There’s no question that holding dividend-paying Canadian stocks (or preferred shares) in a non-registered account offers significant tax savings. If an investor is in a low tax bracket, the dividend tax credit is extremely generous. An Ontario resident earning $20,000 in pension income and another $20,000 in eligible dividends might pay no tax at all after applying all available credits.
But if much of a retiree’s investments are held in registered accounts, the dividend tax credit has no benefit at all, so focusing on Canadian dividend payers in an RRSP or RRIF is hard to justify.
Moreover, Canadian dividends must be grossed-up by 38%, so every $1 in dividends counts as $1.38 in income. That can nudge retirees over the threshold for clawbacks to Old Age Security. That’s why capital gains can be preferable to dividends: not only can they be deferred until it’s favourable to realize them, but only half the realized gain counts as income.
Diversification can suffer. Dividends from U.S. and international stocks are not eligible for the dividend tax credit: they are fully taxable as income. For this reason, it can be tempting to overweight Canadian stocks in non-registered accounts. While this makes sense from a tax perspective, it can also lead to poorly diversified portfolios: it’s all too common to see retirees’ portfolios loaded up with bank stocks, in particular. While these have performed well recently, it’s risky to concentrate one’s wealth in a single sector of a single country.
You can reduce risk by holding a globally diversified portfolio with roughly equal amounts of Canadian, U.S. and international equities (including both developed and emerging markets). If foreign equities are held in non-registered accounts, total-market funds are likely to be more tax-efficient than those focusing on dividends. Because capital gains are taxed at half the rate of foreign dividends, one should prefer a 5% capital gain and a 2% dividend over a 3% capital gain and a 4% dividend.