How to handle the RRIF dilemma

I keep getting desperate e-mail messages from RRIF investors seeking help. They’re caught in a bind between economic reality and government policy and don’t know where to turn.

The problem has two facets.

1) Under existing law, you’re required to withdraw a minimum amount of money from a RRIF every year. Up to age 70, the amount is calculated by dividing the value of the RRIF on Jan. 1 of any given year by 90 minus your age on that day. So a 65-year-old with a RRIF worth $100,000 would have to withdraw at least $4,000 that year. For those 71 and older, the government has established a withdrawal scale that increases each year. At 71, it is 7.38 per cent of the plan’s value, at 75 it is 7.85 per cent, etc. (Note: this scale applies to RRIFs created after Jan. 1, 1993; earlier plans have lower withdrawal minimums.)

2) With interest rates so low, investors find that they can’t generate enough cash flow from traditional income sources like GICs and bonds to offset the withdrawal requirements and the older they get the more difficult this becomes because of the ever-increasing minimums.

The net result is that ny retirees are encroaching on their capital at a much earlier stage than they had anticipated in order to meet the government requirements, thereby creating the possibility of a real financial crunch in the future.

Consider, for example, the plight of a 72-year old with a $50,000 RRIF who has invested the entire amount in GICs – not uncommon, incidentally. Under the law, she must take $3,740 from the plan this year. But the current interest rate on five-year GICs at the major banks is about 3 per cent. Even if she is using a laddered approach, her average return is unlikely to be more than 4 per cent. That means the RRIF is only producing $2,000 income each year – slightly more than half of the total she must withdraw. It doesn’t take a mathematician to figure out that the principal is going to erode very quickly at this rate.

The federal government could easily solve the capital depletion problem by greatly reducing the minimum withdrawal requirements or tying them to a fluctuating rate, such as the average T-bill yield. But thus far, no one in Ottawa has shown any inclination to propose such amendments, despite representations from seniors’ organizations like CARP.

So the ball is in the court of individual RRIF investors. Either be content with low returns and watch the value of the plan decline, or create a portfolio that will generate the required cash flow to at least meet the government minimums.

Next page: Taking on more risk

The second option requires taking on more risk. GICs, T-bills, mortgage funds, and short-term government bonds simply won’t do the job. So you’re faced with a fundamental decision: do you invest in higher-risk securities in order to produce more cash flow, or do you stay with low-risk assets and accept the inevitability of a steady decline in your capital?

It is possible to put together a mutual fund portfolio that can produce the income you need with a reasonable level of risk. But you have to plan carefully and choose only top-level funds. Here are some that I think fit the bill.

TD Canadian Bond Fund.  You should have a good core bond fund to start, one that pays regular distributions. This is a fine choice. It’s no-load, is a steady above-average performer, and pays high quarterly distributions. Cash-on-cash yield over the past 12 months is 5 per cent, based on a recent NAV of $12.85. Total return in the year ending Aug. 31 was 8.8 per cent.

TD High Yield Income Fund. Regular bond funds are fairly low risk. Here we move up the risk/return scale. This is a high-yield bond fund that invests in what some people refer to as “junk bonds”. They are actually corporate securities that have a relatively low safety rating (“B” or better in this case) and therefore pay higher interest rates. This category of fund has scored some major capital gains this year, but that’s not your prime concern. You are looking for cash flow and this fund has it, with monthly payments currently running at 3.5c a unit. Cash yield over the past 12 months was 7.5 per cent, based on a recent unit price of $9.21. One-year total return was 19.3 per cent. Don’t expect a repeat of that in the next 12 months, however.

AGF RSP Global Bond Fund. You may want to add a global bond fund to your RRIF for currency diversification. This one holds foreign currency denominated, Canadian-issuer bonds and bonds of international agencies such as the World Bank. It recorded a 5.3 per cent return in the year ended Aug. 31, well above both the peer group average and Citigroup World Government Bond benchmark index. But what counts most is the good cash flow. The fund pays quarterly distributions which are currently running at about 4c a unit. Over the 12 months to the end of August, total distributions were about 44c a unit, for a cash yield of 3.9 per cent, based on a recent price of $11.28. Risk is average for a fund of this type.

Talvest Millennium High Income Fund. The best cash yields come from income trusts funds, but the risk level is much higher than with any bond fund. This is one of the better income trusts funds still open for new investors. It pays monthly distributions at a rate of 6c a unit, with a special capital gains distribution in December. Over the 12 months to Aug. 31, the total distribution was just over 73c per unit, for a yield of 7 per cent based on a recent price of $10.41.

GGOF Monthly Dividend Fund. Your RRIF portfolio should include a good dividend fund. This one invests in a combination of high-yielding common stocks, preferred shares, income trusts, and bonds. So it offers some growth potential as well as good cash flow. Distributions are currently paid at a monthly rate of 3.5c per unit. The cash-on-cash yield over the past 12 months was 4.7 per cent, based on a recent price of $8.84 (Mutual Fund units). One-year total return was 11.2 per cent.