When the time comes for investors to start taking income from their retirement assets, a common approach is to create these payments through a Systematic Withdrawal Plan (or SWP) from a mutual fund. If this is the case, a number of mutual fund units are sold each month to create the amount of income you are withdrawing. This works well when markets are generally rising. As the market value of a unit grows, it takes fewer and fewer units to create the desired monthly cash flow. However, in sideways or volatile markets such as we have experienced since 2000 there is a danger in selling off units that have not increased in value — or worse — have declined in value. In that case, an increasing number of units has to be sold to create the needed income. This will have a negative impact on the capital base. When markets rise again, there are fewer units to restore the value. (The risk issue of making withdrawals from an account during years of flat and/or negative returns is detailed in Your Retirement Income Blueprint 2nd Edition — pages 66 – 68 and in Your Retirement Income Blueprint 3rd Edition — pages 66 – 67.)
If a falling market impacts their capital base in this way, retirees are naturally stressed by watching the market value of their income-producing assets decline. And at this time of their lives, many investors have the time and inclination to be checking the value of their accounts with increasing frequency – sometimes daily! This can lead to stress and worry, and a loss of confidence in the ability of their assets to create enough income over time.
What if, instead, the investment was designed in such a way as to preserve the number of units and pay out a monthly fixed distribution – e.g. cents per unit – over the long term? In this way, the capital base is not eroded and the same level of income is sustained, regardless of the current market value of the underlying units.
A similar payout attribute could be said of a bond delivering interest, or a stock which delivers dividends. But in this case, the yield on such instruments is low and/or there is limited opportunity to diversify adequately in an individual’s portfolio from a risk and asset class perspective — and if you want to further enhance your cash flow, you will have to sell a stock or bond position to do so and erode your capital base as a result. A fund structure can reduce risk and accomplish all the distribution objectives internally without the individual investor having to sell personally-held units. The monthly payout may be comprised of any combination of interest, dividends, trust distributions earned by the fund from bonds, dividend-paying stocks, REITs, real estate, infrastructure, private equity etc. and may also include ‘constructive’ return of capital (ROC).
Historical payouts on well-managed funds have been consistent, as investment managers do try to establish the payments based on what they believe to be sustainable receipts from the underlying investments. They cannot, however, be considered as guaranteed. The amount of fixed payout can change if the environment – such as we have experienced with bond yields — changes. It takes some investor due diligence to investigate the quality and experience of the manager of such a fund.
These fixed-payout monthly income funds are particularly well-suited to non-registered savings and TFSAs. We have found this to be one of the best ideas for meeting the challenge of creating sustainable income in this low-yield / high-volatility environment … and our clients are telling us that they are no longer focused on or stressed over the day to day movement of the stock markets.