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:
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.
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.
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.
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.
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.
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.
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.
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).
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."
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.