Don’t whiff on RRIFs

Boomers are heading into retirement at a bad time. The staple of retirement investing — fixed income — isn’t delivering the way it used to.

Magnifying the problem is the otherwise welcome fact that people are living longer. Clients who’ll rely heavily on their RRIFs may have to take on more risk than retirees are accustomed to.

Investing RRIF assets

Jim Otar of Otar & Associates suggests moving equity holdings into dividend-paying funds five-to-six years before converting RRSPs to RRIFs. Clients should also have no more than half their portfolios in equities, and the fixed-income portion should use mainly shorter-term bonds.

Advisors need to consider three main risks:

• Market – fluctuations can lead to a sequence of negative returns, and there’s not enough time in the retirement phase to recoup them
• Inflation – the purchasing power of savings dwindles as inflation rises
• Longevity – longer life spans raise the risk of running out of money

Otar says longevity risk is particularly important given longer life expectancies and that advisors should plan to age 95 for men, and 97 for women.

“If you use the average life expectancy — 79 for men, 83 for women — there’s about a 50% chance clients will be alive when their money runs out. That is far too much risk.”

Bev Moir, senior wealth advisor and financial planner at ScotiaMcLeod, varies her approach depending on when and how clients plan on drawing their RRIF payments. Wealthier clients who don’t rely on RRIFs typically take payments all at once at year’s end. This allows them to grow their money tax-free as long as possible. “For this type of client I try to have bonds that come due on December 1,” Moir explains.

Some clients are not very disciplined with their cash flow and want to treat their RRIF like a monthly pension payment. “In that case, I may use equities that produce monthly cash flow, like balanced funds or publicly traded REITs,” Moir says.

Some clients want the entire RRIF payment at the beginning of each RRIF year. In this case, Moir uses a five-year laddered-bond strategy. A bond will come due every year at the point the client wants to draw the funds.

For these clients, Moir says she takes a conservative approach to RRSP contributions made five to seven years before converting to the RRIF. She keeps them in cash or shorter-term bonds to plan for a $50,000 payment, for instance, on day one of the RRIF period.

It’s important to maintain enough flexibility to take advantage of good buys. How much cash and equities a client has depends on age, asset levels and expenses, but the portfolio should have enough liquidity to seize immediate opportunities, says Moir.

“In the midst of the 2008 crisis Canadian financial institutions were issuing a lot of Tier 1 capital bonds. A 10-year bond that I put in clients’ accounts pays 7.24% interest per annum — equity-like returns out of a bond from a high-quality issuer. It was nice to have the cash available to seize this opportunity,” she explains.

While risk tolerance decreases in the draw-down years, clients can’t be too conservative in the current environment. RRIF rules say a 72-year-old client must draw 7.4%, but if a large chunk of her investments are stuck in vehicles earning 2%, she’ll encroach on principal too quickly.

When fixed-income returns were in the 7% to 9% range, advisors could ladder them over a 10-year period. Every year the client had a bond coming due with a great return, and that would be the RRIF payment.

“But in the current environment, with yields so low — a 10-year Government of Canada is 2% — I’m looking more at balanced mutual funds and dividend-paying equities” to extend the RRIF’s best-before date, Moir explains.

“It’s more risk than clients normally take on at this point in their lives. But it’s important to discuss this option with them,” she adds.

The annuity option

Longer life spans and less-than-stellar yields from fixed-income products make annuities the best option for some clients, says Otar.

There’s a simple way to determine this. Say the client has $300,000 of retirement savings, annual income needs of $15,000, and a 30-year time horizon.

The yearly withdrawals will drain the retiree’s savings by the twentieth year — a decade shy of the 30-year target. This client needs an annuity.

“It usually takes some convincing,” Otar says. “Most don’t want to part with the money; in some cases they simply have a negative impression of insurance products.”

The best approach to persuading these clients is to show them, with a visual aid like a graph, that they’ll outlive their savings unless they purchase an annuity.

Moir also uses annuities in certain cases. One of her clients has a $500,000 RRIF and worries about running out of money. He can liquidate half the RRIF and buy an annuity, guaranteeing a lifelong income stream. The remainder of the RRIF will fall into a balanced, diversified portfolio. “This is for people who need to make their money last longer but don’t want to elevate their risk with more of an equity component,” she explains.

Tax implications

RRIF withdrawals are taxed based on the client’s bracket.

To lessen the burden, clients 65 or older can claim federal and provincial pension income tax credits for RRIF income, explains Wilmot George, director of tax and estate planning at Mackenzie Investments. The federal credit works out to about $300, and assumes at least $2,000 of RRIF income. The provincial credit is similar but usually smaller. Typically the total credit is about $400.

George notes this only applies to clients who don’t have pension income that eats up the credits. A retiree who doesn’t rely heavily on RRIF income, thanks to a pension or other income stream, should place it in a TFSA if she has room.

While the RRIF payment is still subject to tax, future income generated by the remainder will be sheltered within the TFSA. Clients also have to consider taxation at the time of death. RRIFs can be transferred at death into the RRSP or RRIF of a spouse or common-law partner without triggering tax. They also can be transferred in the same tax-deferred way to physically or mentally challenged dependent children.

Otherwise, George says, “The client can be in a lower tax bracket during retirement years, only to be subject to the top bracket at the time of death because of the total disposition of assets.”

RRIF nuts and bolts

• Canadians are legally required to convert their RRSPs into RRIFs by December 31 of the year they turn 71, though they’re free to do it earlier. The transfer is not a taxable event.
• RRIFs are subject to yearly withdrawal minimums, but there is no maximum. The younger the client, the lower the minimum: a 65- year-old has to pull out 4%, a 90-year-old 13.62%.
• A client with a younger spouse or common-law partner can use her spouse’s age to calculate the minimum withdrawal. This would enable her to shelter more income in the RRIF.
• The client is committed to withdrawals after she sets up the RRIF. “But she can transfer it,” explains Wilmot George, director of tax and estate planning at Mackenzie Investments. “Say she uses her own age on the application, but five years later she decides she wants to use her spouse’s age. She can terminate her original RRIF and set up a new one without any tax implications.”