Magazines have a long lead time. When we agreed to do this article, the GTSX was over 14,000 points and rising, and it was expected Canada might skirt the U.S. recession with minimal damage. A 40% decline in stocks worldwide was on no one’s radar.

Good-quality stocks that paid a 3% dividend a year ago now pay 5%. That’s good news if you’re approaching income production today with cash, but no help if you were fully invested throughout the downturn.

Guarantees, even overpriced ones, are starting to look a lot more attractive to both advisors and clients. If you were invested a year ago, those guarantees are valuable, but do they really make any sense starting from a market bottom?

Even though a lot has changed, the basic principles of designing a retirement portfolio for clients and producing safe, reliable income have not.

So let’s review those basics and show how your practice will benefit from a repeatable, disciplined process for income portfolio design and that your procedures should be centred on individual clients and their goals, needs and priorities. We’ll also look at how radically different withdrawal math is from accumulation math, and make the case that tax efficiency and reasonable costs are critically important elements to success, and show how to achieve those objectives.

To do that we’ll look at case studies, ignoring the easy ones involving multimillion-dollar accounts, and instead focus on clients who need their $700,000 portfolios to provide a lifetime of indexed income. The resources are the same; the difference in the case studies is the client objectives and priorities.

The Challenge
Producing income for clients who are retiring will be the dominant theme of your practice over the next 10 to 20 years. The leading edge of boomers has now reached age 63 and the fattest part of the bulge is right behind them. Even if you’re entirely focused on younger people now, your day will come. For those practising for 25 years or more, this is already the biggest challenge.

It is also our highest calling. All those years of helping people become more disciplined and systematic in their saving and investing have helped them accumulate much more money than they would have on their own. They now have the capital to form the basis of their retirement incomes. But that was simply the means to an end. The real reason to accumulate wealth is so you can produce income from property, instead of from human toil.

In an ideal retirement-income scenario, clients have sufficient assets to be able to generate the cash flow they want through government benefits, pensions and the dividends and interest that they are paid from their investment holdings. Asset values will fluctuate but the interest and dividend payments would create their income and remain relatively stable. It’s like owning a rental property. The buildings will fluctuate in value, but rental income is relatively constant.

But this is not an ideal situation. If we use those Canadians who are eligible for the Old Age Security (OAS) benefit as a measure, only 3% of them have net incomes that eliminate them from receiving any of this pension (just below $105,000 in 2008). This means that for the vast majority of retirees, it’s not a case of satisfying their income needs from dividends and interest, it’s about encroaching upon principal. It’s about using the capital that’s also responsible for generating income. As such, advisors need to be able to help clients intelligently disassemble what they spent a lifetime accumulating. Doing this in the most efficient manner is all part of protecting capital and asset conservation.

The major efficiencies in this process are achieved by understanding and employing a few principles:
1. Never sell low—almost every strategy is designed around avoiding this.

2. Start with your client’s goals and objectives, and make sure you understand them fully, including their fears and risk tolerance (their real ones). Determine what their priorities will be if times get tough.

3. Encourage them to invest as much time as needed to get an accurate understanding of their income needs, and plan out their requirements for one-time capital withdrawals—things like cars, furnaces, trips, and other unexpected but repeatable needs.

4. Base your income production plan and investment recommendations on this information.

5. Set up a cash wedge (money market and short-term guaranteed instruments) to cover off the next three years of income needs. Replenish this wedge regularly from income produced on the investments and profits taken when the opportunity to sell high presents itself.

6. Do not use systematic withdrawal plans (SWPs). If you believe that dollar cost averaging works, then you have to believe that SWPs are a guaranteed loser.

7. Focus on minimizing taxable income and net income, after becoming fully educated about the tax credits that might be available to this client, and how they would be reduced by every dollar of additional net income. (see “Take it Down”).

Let’s examine the age amount as a prime example. An individual aged 65 and over is entitled to the full age amount if her taxable or net income is less than $30,524. For every dollar of net income in excess of this, the age amount is reduced by fifteen cents such that at $66,693, there is no more entitlement.

The same mechanics apply to the potential reduction of the OAS benefit for those over age 65. Payments are reduced by fifteen cents for every dollar of net income in excess of $64,718 and the OAS entitlement is eliminated once net income is at $104,903. The key for the advisor is to ensure that any such reductions don’t happen needlessly. Otherwise, it’s an inefficient form of double taxation for the client and puts unnecessary, additional stress on the incomeproducing assets.

Balancing Act
If you’re old enough to remember the Ed Sullivan show, you may recall the performers who came on stage to spin plates on top of long sticks. The point of the exercise was to run around and keep a bunch of plates spinning at the same time and not have one fall. As advisors in the income market, we need to be able to multitask at that level; and pay attention to client objectives and demands, some of which may seem to be contrary to one another. For example, clients want to use their assets, while at the same time insisting on preserving them. We are investing conservatively for income, but also need to experience some growth to deal with inflation. We’re required to balance the shortterm and long-term use of their assets, without knowing how long they’ll stay healthy or alive. And some clients want to have the freedom to spend, but also have a desire to leave a legacy.

The priorities and objectives of our clients will change as they move through their retirement years. We need to be flexible to help them address these changes. Think of the plate spinner now having to perform with a gust of wind coming through the stage door and a floor suddenly littered with ball bearings. That’s our role in a volatile market like this one.

Efficient Income Delivery
There is as much importance in how we deliver, or layer, the income for the client as there is in the selection of investments and financial tools that we employ. Considerations in this process include:

1. Using the least flexible income sources as they are available.

2. Using the least tax-efficient income sources in lower tax brackets.

3. Working efficiently within the tax brackets.

4. Looking for income-splitting opportunities.

5. Determining which assets are best to use and which are best to defer.

Case Study
We have two couples that have identical situations—Carl and Paula, and Archie and Edith. All four are age 62 and all have made the maximum contributions to CPP and, as such, are entitled to the maximum retirement pension. They also have ascontinued sets and income entitlements.

Both ladies worked for the Widget Corp. and have each accrued pension income of $2,000 per month for life, not indexed. The pensions are joint life with 66 2/3 survivor benefit and a fiveyear guarantee.

Archie and Carl were not in pension plans. They’ve built retirement assets in their own respective RRSP accounts, which amount to $400,000 for each of them. The RRSP account values for Edith and Paula are $100,000 each, and both couples have jointly held nonregistered accounts worth $200,000.

In both cases we’re focusing on creating income from assets and benefits and not using real estate or any potential inheritances. Both couples are looking for monthly household incomes of $6,000, after tax. What’s different about these two couples is their approach to how they use their assets.

Carl and Paula will follow the five principles we have previously identi- fied. They love their children, and want to make sure that they leave behind a substantial estate. Their main goal is to preserve capital.

Archie and Edith could care less about the kids. Now that they’ve finally got them out of the house, after years of education funding and freeloading, they’re on their own. These are the people who smile at the idea of dying broke. Edith and Archie have their own ideas on how to draw their income. (Either that, or they’re using an advisor who is not necessarily proficient in the area of income planning.)

So let’s begin with Carl and Paula. Paula has commenced income from her pension and she and Carl have each triggered their CPP retirement benefits. Yes, it would be 18% less than the maximum available today if they were 65, but they will receive 36 payments in advance of that date.

The other advantage, ultimately, is that by taking early benefit at an amount lower than the maximum, the one who outlives the other will have the opportunity for a survivor benefit top-up. If they waited until age 65 and each was entitled to the maximum, there would never be an opportunity for a survivor benefit top-up.

Paula will also transfer at least $2,000 of pension income to Carl’s tax return each year, to utilize the pension income credit for Carl. (With couples having more unequal pension and assets splits, there would be a much greater need and value from pension transferring. The rules are different before 65 and after.)

They will withdraw enough RRSP income for Paula so that she has taxable income up to the top of the first federal tax bracket. Even if they don’t need this additional income to meet their cash flow needs, they can take the after-tax dollars and invest them in non-registered accounts.

Perhaps this can be directed to the Tax-Free Savings Account (TFSA) available each year starting in 2009. This will also help Paula (who will have $6,000- plus per year in OAS income in three years) preserve more of her age amount and age credit once she reaches age 65.

Carl has his CPP benefit of roughly $7,300 per year and will also have his OAS entitlement that will create cash flow of $3,000-plus at age 65. So, to keep him below the first federal bracket, we should take about $30,000 from his RRSP/RRIF account to get him to that level prior to his reaching age 65. When OAS starts, we can then cut back that amount from the RRIF withdrawals. Again, any withdrawals not needed for their regular cash flow can be converted to non-registered investments and deferred. The strategy is both survivor- friendly and estate-friendly.

This approach should also ensure that, after age 65, very little, if any, of the age amount and age credit will be lost, especially if the existing (and any additional) non-registered investments are invested in a tax-effective manner.

They are paying tax at the lowest marginal rate, taking steps to preserve government benefits and entitlements by keeping net income low throughout their retirement and systematically converting fully taxable income to taxefficient assets.

They can also consider using their TFSA and other surplus savings to fund a joint, last-to-die life insurance contract, to satisfy their desire to pass a large estate to their family. This would give them greater freedom to spend what they’ve saved.

Edith and Archie have other ideas. The fact that RRSPs are tax-deferred is a perfect reason, they think, why they should not be used at all until required.

Like Paula, Edith triggers her pension income immediately. But Edith and Archie both decide to defer their CPP retirement income, since they don’t want to take the reduction that accompanies payment before age 65. Too bad. They miss the future opportunity to have the top-up on the survivor benefit, plus the income they would have realized over the next 36 months. But there is another disadvantage to their strategy. They’ve chosen to use the non-registered account to create the cash flow they need between now and the time they turn 65. They are using their own assets instead of government benefits and are using the most tax-effi- cient assets they have to deliver income when they are in the lowest tax rates.

So where are they on their 65th birthdays? They now have maximum CPP pensions, OAS, Edith’s pension income and larger RRSP balances than they did three years ago. When they start to take the fully taxable income from their RRIFs, they’ll quite likely jump into the next tax bracket and require higher withdrawals to create the same after-tax income. As they move through their retirement years after age 65, they will lose more of the age amount and age credit than Paula and Carl. When either Archie or Edith dies, the survivor will have fully taxable assets (or income) transferred into his or her name. This may result in a higher required amount of taxable income. This could not only mean a total loss of the age amount and credit, but could also result in a clawback of OAS payments. The fact that the estate will be in receipt of mostly fully taxable assets means less for the heirs. (But that outcome is at least not out of sync with their objectives.)

Two identical situations. Two very different outcomes.

Ultimately, the goal is to optimize the assets clients have taken a lifetime to accumulate. To do so, consideration must not only be given to effectively creating their income today; we must also consider how today’s decisions will impact how we create their income in the future, income for the survivor and the resulting impact for heirs and the estate.