Carol Bezaire, CFP, TEP, CLU, is vice-president of tax and estate planning at Mackenzie Investments.
Mikhail Filitov, 64, is a civil servant planning to retire in a year. He’s widowed and only needs to support himself. His pension will cover basic expenses, but he also has a conservatively invested $950,000 portfolio. He wants steady, safe growth to pay for long-postponed travel and his two hobbies: woodworking and golf.
Mikhail’s risk aversion made him a perfect fit for character conversion mutual funds. They let interest from fixed income be taxed as capital gains, and he gets the safety of bonds with the tax efficiency of equities.
But Budget 2013 nixed the forward derivative contracts that make this possible. Mikhail’s advisor has time to react, and set up a meeting with two objectives:
- Explain what made these funds a target on Budget Night, as Mikhail is an inquisitive client
- Reassess Mikhail’s priorities and decide what to do with the money tied up in two existing character conversion funds.
Carol Bezaire, vice-president of tax and estate planning at Mackenzie Investments, breaks it down (see “Investment example,” below).
It’s clear why the government targeted these funds: their derivative structure means CRA gets less than if investors bought bonds directly.
Initially, the government said contracts had to be wound up within 180 days of Budget Night.
Degree of difficulty
6 out of 10. Communication’s the most difficult part. Character conversion funds are complex and a good advisor will take the time to formulate a straightforward explanation for those who aren’t satisfied with being told the government’s made new rules. Some clients are visual learners, so use your whiteboard to map out the fund’s structure.
But fund companies rushed to point out some offerings had agreements expiring after the deadline; others have rolling contracts that renew every 30 days. And a deal’s a deal. The government backtracked, and issued new requirements in July.
Short-term contracts (less than 180 days) with rolling renewals can continue until December 31, 2014. Contracts expiring after 2014 can run their course, but the last day for character conversion is March 22, 2018.
Clients can still enjoy the tax benefits, but in most cases they can’t beef up positions. Also, funds can’t take new investors. Fund companies can discontinue affected offerings.
Another option is to reorganize them as direct fixed-income investments.
“So, instead of having exposure to Firm ABC’s corporate bonds via a derivative contract, Fund A will now buy $100,000 worth of ABC’s bonds,” Bezaire explains. “The fund will get the 3.5% annual yield, so it’s earning roughly the same as under the previous arrangement. But returns are now interest income, so they’re not tax advantaged.”
Changes to character conversion funds could result in tax penalties for clients
But it’s not all bad.
The contract adds 75 to 100 basis points to unitholder fees. “When the fund’s reorganized,” notes Bezaire, “savings are passed on to investors.”
The manufacturer told Mikhail’s advisor both funds will be reorganized at the end of 2014.
One option is to simply keep them. “This means less tax efficiency,” says Bezaire, “so the advisor should move the positions to a TFSA or RRSP if there’s room.”
She suggests another tack: “Now that the economy’s recovering […] he might consider moving into a balanced fund of bonds and equities. It’s conservative and has low volatility.”
Another option is a fund with a similar mandate to the reorganized investment, but in a T-Series or Systematic Withdrawal Plan (SWP) version.
“With an SWP, if Mikhail wants $500 a month he’ll get it via liquidation of fund units,” Bezaire explains.
She adds that because it’s mostly return of capital, the cash flow is tax efficient. With the T-Series, the distribution is based on the fund’s NAV; it’s mainly non-taxable return of capital. Mikhail has no TFSA or RRSP room, so the first option’s out.
The advisor’s been with Mikhail for more than 20 years, so he knows his client well.
Even though the balanced fund is as conservative as they come, he expects that Mikhail will recoil at the idea of adding equities.
The manufacturer offers a T-Series version of the reorganized fund. This is the most attractive option as Mikhail will soon need retirement cash flow.
Mikhail accepts his advisor’s recommendation. More equity is out of the question and it’s time to start pulling cash from his portfolio. He’ll reap the tax benefits of his character conversion funds until the end of 2014 and then replace them with T-Series bond funds.
Dean DiSpalatro is the senior editor of Advisor Group.