How to build your RRSP income

It wasn’t long ago that we described the three main asset classes as: cash, equity, fixed-income.

Now, the term “fixed-income” looks almost archaic. It’s still accurate when applied to bonds, GICs and the like. You invest a certain amount of money for a period of time at a set rate of return. Fair enough.

But the low interest rate environment has spawned a plethora of new income securities with returns that are anything but “fixed”.

Income securities have changed
These include:

• Royalty trusts
• Income trusts
• Real estate investment trusts
• Limited partnerships

They were created to fill a market void-an income investment providing a higher rate of return than the conventional interest-bearing securities of the past.

So we need to amend the name of this asset cls. The easiest way to do it is to drop the “fixed” preface.

Eligible candidates for RRSPs
Henceforth, these will be known simply as income securities. The list of eligible candidates for inclusion in this category is extensive.

It includes those securities already mentioned as well as:

• Preferred shares
• Mortgage-backed securities
• Some dividend income funds
• Income trusts mutual funds, and more.

Every RRSP should have an income component to it. The percentage of the plan devoted to this asset class will vary depending upon the individual.

Next page: Investor guidelines

Investor guidelines
As a general guideline, the range should be from:

• 20 per cent (younger, aggressive investor) to 80 per cent (conservative, income-oriented retiree).
• Most people should consider an income component in the 30 to 40 per cent range.

The problem is where to put that money, especially in today’s conditions. There is no universal “right” answer, but here are some ideas that may be helpful.

Long-term money:
If you already have some of your RRSP money invested in high-grade income securities, you may decide to leave well enough alone.

Don’t worry about the short-term prospects for the bond market. These too will pass away. Let me give you a personal example.

Many years ago, we began to invest in the Phillips, Hager & North Bond Fund in my wife’s RRSP. We added to the position over time, and never sold any units even when the prospects for the bond market looked lousy.

Simple message
We accepted any short-term pain for long-term gain and stability. Over the past decade, we’ve been rewarded with an 8.7 per cent average annual return. That’s not the best in the Canadian bond category, but it’s well up there. And it’s a very acceptable figure for the income component of Shirley’s RRSP.

The message is simple: If you don’t want to worry about interest rate movements and bond price fluctuations, you’re in for the long haul, and you want to keep things simple, then find a good general purpose bond fund for your RRSP and stay with it. (PH&N Bond is on the Internet Wealth Builder Recommended List)

Short-term money/new contributions:
If you don’t like the thought that the new bond fund units you buy now may decline in value over the next year (however temporary that may be), you’ll need an alternative strategy. There are two possibilities:

• The conservative approach is to choose low-risk income securities.

These would include short-term bond funds such as Altamira Short-Term Canadian Income, mortgage funds, a bond ladder going out no longer than five years, etc.

• The aggressive strategy is to use the stock market as your income vehicle.

For example, invest in an income trust that is based on a portfolio of equities, but is designed to generate substantial cash flow.

On the recommended list
The Mulvihill Premium U.S. Fund (FPU.UN), currently trading at $22.05, is an example from the Recommended List (it would be foreign content in an RRSP).

The middle ground is a blend of conventional income securities (e.g. bonds, bond funds) with some REITs (Riocan is one recommendation) and income trusts funds (GGOF Guardian Monthly High Income Fund is on the Recommended List).

Next page: Middle ground approach

Middle ground approach:
Here’s what the income component of an RRSP that adopts such a middle ground might look like:

• GICs, short-term bonds/funds: 20 per cent
• Mortgage-backed securities, mortgage funds: 20 per cent
• Mid-term bonds, regular bond funds: 20 per cent
• Foreign bond funds: 20 per cent
• Income trusts/funds: 20 per cent

Pay careful attention
This mix provides downside protection while at the same time offering upside potential and enhanced cash flow through the income trusts component.

It also provides a currency hedge in the foreign bond fund. These will come to your rescue if the loonie drops further.

You can juggle the numbers to meet your specific needs.

The point is that unless you’re content to simply put the entire income component into a good bond fund and just let it sit, you need to give some careful attention to this side of your RRSP.