Squeeze more from your RRIF

RRIFs are different from RRSPs. After many years of RRSP conditioning, that’s often difficult for a new RRIF investor to grasp. But it’s essential that you do so, otherwise you and your RRIF could end up pulling in opposite directions.

While you were contributing to your RRSP, your primary goal was to build as large a capital base as possible, consistent with the amount of risk you were prepared to take.

  • Growth is the main objective of an RRSP portfolio.

In the case of a RRIF, however, growth is no longer the number one goal. Now you need to focus on income, with an increased emphasis on safety. Growth drops to third on the priority list.

  • You’ll probably need to reconfigure much or all of your RRSP portfolio when the time comes to convert to a RRIF.

You shouldn’t eliminate all growth potential from your plan, but you may want to structure the plan differently so your growth assets (stocks and equity funds, primarily) can contribute to the cash flow you’ll need.

Problem: low interest rates
Planning a RRIF portfolio has been made more difficult by the low-interest-rate world in which we have been ling. In the past, people could rely on safe fixed-income securities to generate the cash flow they required from their plan. That is no longer the case. You need to look for alternatives, and the older you are the more difficult finding them becomes.

Here’s an example:

  • Let’s suppose you retire this year at age 65 and plan to start withdrawing money from a RRIF next year. You are still 65 next January 1 (your birthday is in July), and your RRIF is worth the tidy sum of $300,000. On this basis, the minimum annual withdrawal from your RRIF in your first full year of retirement will be $12,000. That represents 4 per cent of the total value of the plan.

    Now 4 per cent isn’t difficult to make up. Depending on where interest rates are at the time, a Government of Canada bond or a GIC will likely generate enough interest income to cover the payment with some left over.

  • Let’s assume your RRIF earns an internal return of 5 per cent that first year. So $15,000 comes into the plan, while $12,000 is paid out. At the start of the next year, when you are aged 66, the RRIF has increased in value to $303,000. Your minimum withdrawal that year will be $12,625, or about 4.2 per cent of the asset value. Your 5 percent fixed-income security will still cover that, but the margin is thinner.

  • Let’s leap ahead to the year in which you are 71 years of age on January 1. Let’s say that at this stage the RRIF value is back to $300, 000. According to the government’s minimum withdrawal tables, you must take out at least 7.38 per cent of the plan’s value this year-a total of just over $22,000.

  • Now you’re in some trouble if you want to stick with fixed-income securities. You can’t find any GICs or quality bonds that pay anything like that high a return. So what to do?

    Higher-Yield Securities
    You have a choice.

    • One option is to start drawing down capital to make up the difference. But that sets you on a slippery slope, because every year more of your capital will need to come out of the plan to meet the minimum payment requirement.

    • Alternatively, you can look for other types of securities to help to increase the cash flow from your plan. They do exist. It’s a matter of deciding whether you can accept the increased risk that accompanies them.

    Some options:

    • High-Yield Bond Funds:
      These funds invest in a portfolio of lower-rated corporate bonds, to generate better yields. Sometimes known as "junk bonds," these securities are issued by companies or governments that could potentially face financial difficulties in the future-which is why they are forced to pay a higher interest rate to borrow money.

      There are two main risks in purchasing this type of security:

      • Default risk, which means the issuer doesn’t have enough money to pay interest when due or to redeem the notes.

      • Market risk, which could result in the value of your bonds being driven down by a so-called "flight to quality." That’s exactly what happened to junk bonds in the late summer of 1998, and these funds were hit hard as a result.

  • Real Estate Investment Trusts:
    REITs offer the potential for above-average cash flow. Many people don’t like to hold them in a RRIF because the tax benefits are lost. But you should consider them if you want to increase the income stream.

  • Royalty Income Trusts:
    When the market for royalty trusts caved in during 1998, many investors sold their units at a loss and muttered "never again." Unfortunately, in doing so, they have ruled out one of the best weapons available for combating low interest rates.

  • Royalty income trusts offer a return well in excess of anything you can expect from even the most generous GIC. The trick is to choose those with the least downside risk for your plan.

    The cash flow from any royalty trust will depend on the success of the underlying business. If profits decline, so will the payments. The trusts most vulnerable to boom-and-bust cycles are those based on the resource sector-oil and gas trusts and coal trusts in particular.

    We saw just how sensitive they are in 1998, when oil prices dropped dramatically. In response, the distributions from oil and gas trusts fell, as did the market value of the shares. When oil prices rebounded in early 1999 and on into 2000, shares in these trusts followed suit.

    For RRIF investing, I recommend you build a small portfolio of royalty trusts that covers several industries. You might include a retail trust (e.g., North West Company), a pipeline trust (e.g., Koch or Pembina), an electrical-generating trust (e.g., Trans-Canada Power), a staple food supplier (e.g., Rogers Sugar Income Fund), and an energy distribution trust (e.g., OPTUS Natural Gas Distribution Trust).

    These are not risk-free, of course, but the portfolio approach will greatly reduce the downside potential and the yields will be much higher than you can expect to receive from bonds or GICs.

    • High Income Funds:
    A few mutual fund companies have developed funds that invest in a portfolio of REITs and royalty trusts. The most prominent are the Guardian Monthly High Income Fund and the BPI High Income Fund.

    The portfolios are designed to minimize risk, although that didn’t prevent them from taking a big hit when the royalty trust market hit the skids in 1998. As a result, many investors were scared off and missed a good opportunity to acquire high yields at low prices.

    So the key to RRIF investing is to ensure that you have enough high-income securities in the plan to meet your cash flow needs without exposing yourself to too much risk.

    Adapted from Retiring Wealthy in the 21st Century, by Gordon Pape, published by Prentice Hall Canada. (Paperback). To order this book at a 20% off the suggested retail price (plus taxes and shipping) call toll-free, 1-888-287-8229.