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Is it not strange that desire should so many years outlive performance?

     - W. Shakespeare, Henry IV, Part 2, Act II, Scene IV.

Withdrawal Strategy


Sustainable Withdrawal

    Many simple portfolio models assume that the rate of return is constant, and provide a nice, simple graph showing that, with a given asset mix, a withdrawal rate of, say, 7 or 8% will allow the portfolio to last for 20 or more years. 

    Unfortunately, these models are unrealistic because they fail to take into account the variation in returns.  Several academic studies are referenced at the following link:

   How much can you safely withdraw from your savings during retirement?

    When more sophisticated models are used, the sustainable withdrawal rate turns out to be much lower: about 4%, indexed for inflation, before expenses.  This problem is caused by the variation in returns, particularly of equities.

    Here are examples calculated by "gummy" for a Gummy "Random Walk" tutorial.  The chart on the left shows the actual returns of the  S&P500 from 1970 to 2000, as well as the return paths that would have been taken if the results had been ordered from largest to smallest or from smallest to largest.  The graph on the right shows the effect on portfolio life for a 6% withdrawal rate for the different sequences of returns. 

    The red line shows what happens if all the bad years hit right after retirement: you go broke after only 34 months.  The portfolio never recovers from the bad years.

 

 Selling equities when they are low will kill the portfolio. 

   A number of other tutorials, including spreadsheets with various withdrawal strategies, are available from gummy's site.

   Because of the disastrous consequences of selling equities when they are low, systematic withdrawal plans (SWP's) may be dangerous to your financial health.  In these plans, a constant dollar amount of a mutual fund is sold to provide the investor with an income stream.  As discussed in this article, this approach will sell more units of the fund when prices are low, and risks rapidly exhausting it. Instead, investors wanting this approach should consider selling a constant number of units to provide income, NOT a constant dollar amount.  This will give a variable income stream, but extend portfolio life.

   As was mentioned in the section on asset allocation, the retired investor should consider modifying his portfolio so that it provides a dividend yield (using high-quality bonds and non-cyclical stocks and income trusts) that matches the sustainable withdrawal rate.

Dividends are a more reliable source of income than are capital gains.

   Real-return bonds, which usually yield around 3%, should be a major part of the RRSP portfolio.  An asset mix of dividend-paying stocks, preferred shares, and a small REIT content can easily provide adequate dividend yield in the non-registered portfolio. 

    The retiree should also adopt a strategy of selling equities in good markets and living off bond income in bad markets.  Bond income can be accessed either by drawing down the RRSP (or RRIF), or by transferring equities from the non-registered account to the RRSP. 

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Tax Deferral

   Retirees should examine the tax-efficient withdrawal of funds Examples of tax-loss harvesting were given earlier in the section on Cost Control; the same techniques can be employed during withdrawal.  In general, non-registered funds should be utilized before RRSP funds, unless the retiree knows he has only a few years to live.  This effect can be demonstrated with a financial package called RRIFmetic. From the non-registered portfolio, securities with a high adjusted cost base, or mutual funds with high management expense ratios, should be sold first. The sale of non-registered funds - which can be transferred to the RRSP portfolio without affecting asset mix - has the effect of deferring tax.  

Example 1. Joe, who is an Alberta resident in the lowest federal tax bracket, has $5000 of bond income deposited in his RRSP.  Joe needs to access this money for ongoing expenses.  Joe's marginal tax rate is 26% (16% federal and 10% provincial); if he withdraws the money, he would pay $1300 in tax.  Instead, Joe calls his broker and arranges for a transfer of $5000 in XYZ Mutual Funds from his non-registered account to his RRSP.  The XYZ holding has a current unit value of $10.00 and an adjusted cost base of $8.00.  The 500 units transferred are considered a "deemed disposition" by CRA.  Joe pays a $50 transfer fee to his broker. The capital gain is ($10.00 - $8.00) 500 - $50, or $950.  The tax payable is $123.50.  Joe saves a total of $1126.50 ($1300 - $123.50 - $50) by making the transfer.  Tax savings at higher brackets would be even greater.  Joe's portfolio asset mix is affected only slightly; he has withdrawn $5000 and his equity and bond percentages will have increased correspondingly.  Since the XYZ units have not been removed from the portfolio, market conditions are irrelevant.  

Example 2.  Joe has a $10000 bond come due in his RRSP which he wishes to withdraw for a European vacation.  Joe is an Alberta resident at the top of the first federal tax bracket; the withdrawal would occur in the second federal tax bracket at a marginal tax rate of 32%, incurring a tax of $3200.  Joe has more than $10000 Canadian worth of VTI (Vanguard total-market ETF) in his non-registered US account.  Joe paid $150 Canadian for these units, which are currently trading at a price equivalent to $135 Canadian.  If he transfers the VTI to his RRSP, CRA will disallow the loss.  So, Joe sells the equivalent of $10000 Canadian worth of VTI from his non-registered U.S. dollar account and immediately purchases $10000 Canadian worth of a Russell 3000 ETF (a similar but not identical security) in his RRSP.  He then has the funds from the VTI sale journaled to his Canadian dollar account.  Joe pays two currency conversion charges at about 1% each and two brokerage fees, for a total of about $300 Canadian.  The non-registered currency conversion and brokerage charges are included in his capital loss, which is about $1260 Canadian and can be applied against capital gains.  If those gains are in the first federal tax bracket, the tax savings are $163.80.   The total savings in this strategy are $3200 + $163.80 - $300, or $3063.80.

   It is important to remember that in the above examples, the tax is deferred, not avoided.  Eventually, RRSP withdrawals will be taxed, either when the RRSP is converted to an RRIF, or by deemed disposition upon the death of either Joe or the beneficiary of his RRSP.  It is quite possible that a higher tax rate will be applicable at that time than would be paid now.  Nevertheless, by deferring the tax, Joe is both getting present use of the funds and allowing further tax-free compounding within his RRSP.  Unless Joe is certain that he will die within a few years, it will be to his benefit to defer the tax - even if a higher rate is eventually payable.

Example 3. Joe has, in Example 1 above, saved $1126.50 by transferring $5000 worth of XYZ Mutual Funds to his RRSP.  The fund obtains a real after-inflation return of 5%, growing to $8144 in constant dollars after 10 years.  By then, Joe has converted the RRSP to an RRIF.  Let's assume that his marginal tax bracket, including OAS clawback, is now 50% rather than 26%.  Joe sells the XYZ funds and withdraws the money, paying the equivalent of $4072 in tax and netting (in constant dollars) $4072 of the original $5000.  But, if he had withdrawn the $5000 ten years earlier in the lower tax bracket, he would have only received $3700 after tax.  Even with the higher tax rate in 10 years, Joe is still ahead because of the tax-free compounding. Strangely enough, the CRA is also ahead!  However, if Joe died after a year and the RRSP was collapsed, there would be insufficient time to offset the higher tax rate with tax-free compounding.

Example 4.  Joe has transferred all of his foreign equities to his RRSP, but still needs additional cash flow for living expenses.  He now starts selling components of his Canadian stock or REIT portfolio that appear to be fully priced.  He identifies three holdings: PipeCo, a recent purchase yielding 5% and with a cost base that is 85% of the purchase price; BankCo, one of his first purchases, which now yields only 2.5% but has a cost base that is only 20% of the current price; and REITCo, which yields 10% and has an adjusted cost base that is 60% of the current price.  He can get a guaranteed return by selling the PipeCo shares, since they have the highest cost base and will trigger the smallest tax.  Assume that he is still in the lowest federal tax bracket in Alberta, and will sell $10000 worth of shares.  The tax due on PipeCo will be $195; on BankCo, $1040; and on REITCo, $520.  The yearly dividend income reduction would be $500 for PipeCo, $250 for BankCo, and $1000 for REITCo.

   Rather than place the same components in his RRSP, Joe can use ongoing bond interest to add to his RRB or normal bond holdings, gradually reducing his equity exposure.  Alternatively, he can add value ETFs to his RRSP to maintain the same equity weighting while reducing his exposure to individual stocks.  Finally, if stock market conditions are very depressed, he may wish to now withdraw the bond interest directly and pay the tax. The decision on the approach will now depend on market conditions, since the equity mix may be affected.

 
Consider deferring taxes by either selling equities from your non-registered account, or transferring them to your RRSP.

   Investors should also remember that health costs benefit from a tax-credit. Therefore, funds for major medical emergencies should be taken from the RRSP, not the non-registered account.  RRSP withdrawals are normally taxed at the highest marginal rate; using the funds for medical costs reduces the tax rate to the difference between the marginal rate and the lowest rate.  Although tax will be deducted at source for the withdrawal, much of it will be refunded when the tax return is filed.

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Annuitization

    Conservative investors who are in good health face a major psychological hurdle during portfolio withdrawal: they are forced to assume they will live longer than average in order to avoid running out of money.  This limits their withdrawal rate, and that, in turn, may limit their ability to travel during years when they can enjoy it.

    One way around this dilemma is to purchase an annuity from a life insurance company.  An annuity is essentially a life-insurance policy in reverse: a lump sum is transferred to a life-insurance company in return for a stream of monthly payments.  This purchase can be considered as longevity insurance.  An annuity carries a  much higher payout than 4% (indexed for inflation), because the life insurance company is willing to bet that the purchaser's life expectancy is in accordance with actuarial tables - a bet the purchaser can't afford to make.  

   The effective rate obtained with an annuity depends upon the annuitant's age and sex, prevailing interest rates, and the options chosen. Higher payouts can be obtained when interest rates are at a maximum. However, once the annuitant is over about 70, age and sex become more important in determining payout. Men, who have a lower actuarial life expectancy, can obtain a higher payout than can women.   The simplest type of annuity, which has the highest payout, pays the annuitant for the rest of his or her life and has no guarantees.  This is simply a bet with the life insurance company, with the winners being the ones who live longer than average.  Features such as a minimum payout term guarantee (usually 10 years), survivor benefits, and inflation indexing all reduce the available payout.

    Annuity payouts up to $2000/month are guaranteed by the Canadian Life and Health Insurance Compensation Corporation (CompCorp), even if the insurer goes bankrupt. The guarantee is per insurer, so two annuities purchased from two different insurers would be guaranteed up to $4000/month. Because of this feature, and the sensitivity of the payout rate to interest rates when the annuitant is still in his sixties, retirees may wish to take advantage of abnormally high interest rates when they are in their mid-to-late sixties to annuitize a part of their portfolio.  If the purchaser doesn't need the cash flow immediately, a deferred annuity can be purchased that starts payment later.  With either annuity, the purchaser gets a higher cash flow during the traveling years, but leaves a smaller estate.  The remaining portion serves both for lump-sum medical payments and as an estate; it can also be used to purchase a second annuity (perhaps from a different insurer to preserve the CompCorp guarantee) when the annuitant reaches his or her seventies.  The annuity purchase option is considered in this gummy tutorial

   An annuity option that may be attractive to some investors is the back-to-back annuity.  This involves purchase of two different policies on the same day from two different life insurance companies.  The first policy is an annuity; the second is a life-insurance policy for the same amount as was used to purchase the annuity.  The income from the annuity is used to fund the life-insurance policy.  This combination preserves an estate while providing income.  The investor must not need the principal during his or her lifetime, should be in good health, at least 70 years of age, and in a medium or high tax bracket.

   Investors with large embedded capital gains in non-registered accounts may want to consider a charitable gift annuity.  The investor donates shares "in kind" to a charity, which sells them and uses some of the proceeds to purchase an annuity in the investor's name.  The investor gets income and a large tax deduction - plus the pleasure of having made a significant financial contribution to his favorite charity.

   The various types of annuities and annuity strategies should be discussed with an insurance broker by interested investors.  Since insurance companies may deliberately price annuities poorly at certain times if they do not wish to participate in the market, it is important that several quotes be obtained.

Since purchasing an annuity is irreversible, retirees should seek professional advice before making a decision.

    Real-return bonds, which do not vary greatly in price with interest rates, are a good instrument in which to park RRSP or locked-RRSP money pending annuitization.  They can be sold for an annuity at a time when interest rates are high and the purchaser is of a suitable age (generally mid to late sixties).

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RRIF Withdrawals

   Eventually, RRSP holders will face the choice of converting an RRSP to an RRIF (or a LIRA to a LIF or LRIF), or annuitizing.  If they choose the income fund route, they will face mandatory withdrawals that are significantly higher than 4%.  The minimum withdrawal factor for RRIFs entered into after 1994 is given in the following table (from here).  This factor is multiplied times the fair market value of the portfolio at the beginning of the year to give the minimum withdrawal.  The factor is based on "the age in whole years (in the table referred to as "Y") of the individual at the beginning of the year, or the age the individual would have been at the beginning of the year if the individual had been alive then."

 
Age (Y) Factor Age (Y) Factor

under 71

1/(90 - Y)

83

.0958

71

.0738

84

.0993

72

.0748

85

.1033

73

.0759

86

.1079

74

.0771

87

.1133

75

.0785

88

.1196

76

.0799

89

.1271

77

.0815

90

.1362

78

.0833

91

.1473

79

.0853

92

.1612

80

.0875

93

.1792

81

.0899

94 or older

.2000

82

.0927

 

    There are two ways (other than annuitizing) to meet the withdrawal limits, which are significantly greater than the 4% long-term limit: raising the dividend rate or drawing down capital.  The portfolio dividend rate can be raised by including more income trusts or REITs.  One way to do this without increasing portfolio risk is to swap REITs or trusts that are in the non-registered account into the RRIF/LIF/LRIF.  Capital gains tax will have to be paid on the swapped entity (if it isn't in a gain position, sell it from the non-registered account and rebuy it in the RRIF).  Such swaps will meet the increased withdrawal requirements temporarily.  Although it is possible to further increase withdrawals by sharply increasing the proportion of income trusts or REITs, investors should consider such a move carefully, because it significantly increases the risk and may lead to loss of capital if a forced sale is necessary to meet the withdrawal requirements.

   Because of the mandatory RRIF withdrawals, maturing stripped bonds should be replaced by high-coupon normal bonds before the RRSP is converted to an RRIF.

   Eventually, the withdrawal rates will in any case be so great that a draw down of capital is necessary.  The best way to fund such withdrawals is with maturing bonds.  In preparation, equities should be sold down and switched to short-term bonds whenever market conditions are favourable. 

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