Yesterday, I went over the income projection of Dave’s $1 million portfolio that “should” last him for the rest of his life.  Today, I want to go over a few portfolio options to generate that income.

The Portfolio

As I am no where close to being a retirement expert, my investment knowledge for the years during retirement is limited.  However, here is my opinion on the matter.

If it was me with $1 million in cash, with a very low withdrawal rate, I would have a lower equity allocation than the suggested 50/50 split for greater capital protection.  Perhaps it’s my fairly conservative nature, but capital preservation is a high priority when the portfolio is your sole source of income.

But say I did go for the suggested 50/50 equity/bond split, what would I invest in?

The Equities

As the purpose of the portfolio is a combination of capital protection and income generation, I would invest the equity portion in high quality dividend paying blue chip equities, high quality preferred shares and perhaps some exposure to international indices/dividends for diversification.

As it seems that Dave doesn’t have a lot of investing experience, it may be best to stick to ETF’s as it reduces the complexity of choosing individual stocks.  Here are some examples of quality income producing ETF’s:

• Claymore Canadian Dividend and Income Achievers ETF (CDZ) – This ETF follows the Canadian dividend achievers list which includes stocks which have a strong track record of increasing their dividends over the years.  The downside of this ETF is that the MER if fairly high (0.60%) but can be avoided if mimic their holdings via individual stock purchases.
• Vanguard Dividend Appreciation ETF (VIG) – This ETF has a MER of 0.28% and covers U.S stocks that have a track record of increasing dividends over time.  Note that the higher the foreign dividend income, the higher the income tax.
• Claymore S&P/TSX Canadian Preferred Share ETF (CPD) – This is the only ETF that I could find covers the Canadian preferred share market.  It’s has a MER of 0.45% with most of it’s holdings coming from the financial sector (85%).  Preferred shares pay dividends (low taxation) on a quarterly basis, offer the value of higher priority (and yield) over the common share dividend.  However, the downside is that they generally thinly traded and capital appreciation is not as great as the common share.

The Fixed Income

Having a higher fixed income allocation in your portfolio will reduce the volatility while generating a steady income stream but will limit the potential gains.  With all the various fixed income instruments out there, what would I pick?

Personally, I would create a bond ladder with government bonds that mature at the various years/rungs.  This will give you interest rate diversification providing you hold all the bonds until maturity.

But if I wanted to keep it really simple, I would pick ETF’s that cover a combination of real return bonds, short term bonds and corporate bonds with relatively short duration to reduce interest rate risk. Long term bonds, on the other hand, have longer durations along with a higher correlation with equities.

iShare’s offer various bond ETF’s at a relatively low cost.

• iShares Canadian Short Bond Index Fund (XSB) – This covers the short term bond index with a fairly low MER of 0.25%.  All bonds within this index have maturities of between 1-5 years.
• iShares Canadian Real Return Bond Index Fund (XRB) – Real return bonds are government bonds that adjust to inflation on a regular basis.
• iShares Corporate Bond Index Fund (XCB) – This ETF will cover the Canadian corporate bond market with maturities of at least 1 year with a relatively low duration.  Corporate bonds generally have higher yields.  XCB pays semi annually with a MER of 0.40%.

Final Thoughts

So there you have it, if I was approaching retirement with $1 million in cash, my priorities would change from capital growth to capital protection and income generation.  Based on my mock portfolio above and  today’s prices, it would generate a 4.5% yield which is more than enough to meet Dave’s expenses without even touching the capital.

But what if Dave wants to buy a new car or other big item in the future?  I would suggest to save for it like anything else.  Perhaps even withdraw the difference between what the portfolio will allow and regular expenses, then deposit it into a TFSA mad money account.  What’s retirement without a bit of fun?

So what are your thoughts?  What kind of retirement portfolio would you come up with if you had $1 million in cash?

As I mentioned above, I am not a financial advisor. The above is not meant as recommendations but merely for informational purposes only.

24 Comments

Tim emailed me regarding his father in law’s financial situation.  Basically, his father in law is single, no retirement savings, but a ton of equity in real estate which he’s going to liquidate soon to fund his retirement.  Tim realizes that I’m not a financial advisor, but he wanted my opinion anyways.  Here is more about the situation below, perhaps you can chime in with your opinion.

My Father-in-law (Dave) is currently finalizing a sale of an investment property that has appreciated to from his $600k purchase price to a selling now of approximately $1.2 million. The property is fully owned with no mortgage.  The appreciation will be subjected to capital gains tax as this is not a primary dwelling.

My Father-in-law just turned 60 years old and has no pension and limited cash savings other then this ‘paid-for’ land asset.  He only has experience investing in real estate and now that he is ‘retired’ with no fixed income, his priorities have also changed.

• Debt: None
• Dependent Children:  None, two adult children.
• Retirement Status: Has been retired for several years, funded by the sale of another property, but that money is running out – just turned 60
• Marital Status: Divorced
• Employment: He was a business owner – did not have salary, thus no CPP.
• Portfolio: Zero portfolio holdings/RRSP’s or savings of any kind.
• Other Income: None.

House hold expenses:

• Property taxes $4500/yr
• phone/internet/tv $140/mth ($1,680/yr)
• House/car insurance $250/mth ($3,000/yr)
• Utilities Gas/H2O/Hydro $265/mth ($3,180/yr)
• Food $400/mth ($4,800/yr)
• Misc spending $200/mth  ($2,400/yr)
• Gas $200/mth ($2,400/yr)
• Travel $6,000/yr
• Home Maintenance $3,000/yr
• Medical Insurance: $2,000/yr
• Unexpected Expenses: $3,000/yr

Total: $31,960

There could be rental income later on in retirement but for now there is nothing. He does have other land assets – primary dwelling which he does not yet want to sell -it is fully owned. Worth $500k or so. No other plans for future employment. Would like spending cash for travel but MOST IMPORTANTLY wants to have the money invested in a way that he cannot easily access the capital to spend on frivolous items – just have a regular income off the principal investment to play with and live off.

None of this money to be left to the children – so every last penny of this million dollars will be spent. It would likely be preferable to the have current primary residence (approx $500k) as the last remaining asset at death for the children if possible.

Okay – here’s the question, Let’s say you wake up tomorrow morning, sign into your online savings account and BAM! $1 million dollars  - your journey is over – you retire, and now with no fixed income where do you invest your wad of cash to keep it working for you long into your golden years (& beyond?)

The Nest Egg

With $0 in retirement savings, the father in law (Dave) will have to depend on the sale of the investment property to pay for his regular expenses.  With the sale price of $1.2 million net of all costs and $600k being capital gains, there will be substantial capital gains tax to be paid.  According to Tom, the father in law had very little or no income on the year of the sale.

With around $600k capital gains ($300k added to income), Dave will owe approximately $120k income tax (assume Ontario).  Normally in this situation, I would suggest a large RRSP contribution, however apparently, Dave hasn’t drawn a salary (only dividends) for most of his working years thus most likely very little RRSP contribution room is available.

Thus, the proceeds from the sale of his property would be approximately $1.08 million, but we’ll call it an even million in case there are other fees from selling that we aren’t aware of.  With a million dollars in cash, how can a 60 year old ensure that his money will cover his expenses and last for the rest of his life?

Income Generation

According to Sherry Cooper, BMO’s chief economist and author of The New Retirement, a portfolio can survive a 4.2% annual withdrawal rate (increasing annually for inflation) for 30 years with a high certainty of success.  This withdrawal rule was popularized by William Bengen’s research, a MIT grad and CFP, which also suggests that a 50/50 equity bond asset allocation be kept, even during retirement.

Assuming that Dave will live until 90, 4.2% withdrawal from the $1 million in cash will result in the cash flow of $42,000 per year adjusted for inflation annually.  As the portfolio will be non registered, if we assume that 50% of the income will be from dividends (Canadian sources) and 50% from bonds with an average portfolio yield of 4.0%, he will owe approximately $2,200 income tax.

This results in an after tax income of approximately $40,000. As this more than enough to cover all of Dave’s expenses of $32,000 / year,  it will likely result in leaving a nest egg behind for the children which is great news for Tim. :)

In addition to this, when Dave turns 65, he will qualify for old age security.  Assuming that Dave meets the qualifications for maximum OAS, it will mean additional cash flow of $6,200/year in 2009 dollars.  When that time comes, Dave will only be withdrawing 2.78% (including income tax) from his portfolio to meet annual expenses.

Next up is the portfolio for the soon to be retired Dave.  As this article is a bit on the longer side, I decided to split it up into 2 parts.  Stay tuned!

As I mentioned above, I am not a financial advisor. The above is not meant as recommendations but merely for informational purposes only.

36 Comments

A reader asked me to write about retirement benefits so instead of writing a huge article, I thought I would split it up into separate topics.  Lets start with Old Age Security as it’s perhaps one of the more popular seniors benefits for Canadians.  As the information is spread across numerous government websites, I’ll attempt to summarize the main points in this article.

What is Old Age Security (OAS)?

Old Age Security is a (Canadian) government program that pays a monthly benefit (adjusted to inflation) to seniors ages 65 and over.  OAS is is paid out of the current Government tax base (unlike CPP) and is counted as taxable income.

To qualify for this program has nothing to do with if you’ve worked in Canada but how long you’ve lived here.  According to the OAS website, here are the qualifications:

• be 65 or older;
• be a Canadian citizen or a legal resident of Canada on the day before your application is approved;
• have been a Canadian citizen or a legal resident of Canada on the day before you left Canada, if you no longer live in Canada;
• have lived in Canada for at least 10 years since your 18^th birthday to receive OAS in Canada; and
• have lived in Canada for at least 20 years since your 18^th birthday to receive OAS outside of Canada.

For 2009, the maximum OAS benefit is $516.96/month or $6,203.52/year.  To receive this, you would need to have lived in Canada for 40 years after the age of 18.  Anything less than 40 years results in a reduced old age security benefits.  As mentioned above, these benefits are adjusted to inflation which means that they increase over time.

Here is an OAS calculator that you can play around with to get a feel for what you are entitled to (or will be entitled to).

Old Age Security Clawback

You may of heard of the OAS clawback before, but how does it really work?  It’s basically a tax on high income seniors in the form of reduced old age security benefits.  If you’re 65 or older in 2009, the government will clawback 15% of income over $66,335.  Old age security will be completely eliminated for incomes over $107,692.

For example, if you make $75,000 in 2009 and currently receiving OAS, then you will have to pay back some of the benefit.  How much?  It will be 15% of your income over $66,335 or $1,299.75.

Dividends and the Clawback

As you may know, receiving dividend distributions from Canadian public companies qualify for the dividend tax credit which makes investing in dividend paying companies extremely tax efficient.

However, what you may not know is how the dividend tax credit works.  Dividend income is “grossed up” by 45% by which the dividend tax credit is calculated.  This is all well and good for those not receiving old age security, but for seniors, the grossed up amount is used when calculating the upper OAS threshold.

For example, $20k in dividend income is now considered $29k of income which, in certain circumstances, could be just enough to push a senior over the upper OAS limit when accounting for other income sources.

I’m not sure how fair this clawback is, but seniors should consider structuring their portfolios accordingly to reduce the OAS clawback.  Perhaps consider taking advantage of the TFSA as withdrawals are not taxed and do not affect income tested seniors benefits.

Ed Rempel has a great article on TFSA and seniors clawbacks for more details on the topic.

8 Comments