Generating income

When building retirement income strategies for your clients, keep in mind how certain product features can address your clients’ needs and concerns, depending on their specific situation. The table below provides an overview of how each income product category is positioned to accommodate specific client goals. 

Income solutions	Sources of guaranteed lifetime income	Sources of non-guaranteed lifetime income
Investor retirement need/concern	Guaranteed Minimum Withdrawal Benefit (GMWB)1	Mutual funds and traditional segregated fund contracts2	GIA3
Liquidity: Ability to withdraw additional money when needed4	High	High	High
Guaranteed lifetime income provides guaranteed income for life	Yes	NO	NO
Product complexity: The need for ongoing investment decisions and/or the complexity of product features	High	Med	Med
Income flexibility: Choice of when to begin or defer taking income	Med5	High	Med
Inflation protection: Features that can potentially help the investment keep pace with inflation	Med	High	Low

For illustration purposes only. This is a brief summary of various products and their features and benefits. Refer to product-specific materials for more details. The low, medium and high scoring is a qualitative ranking of each product’s ability to meet a specific need or concern when compared to the other products.

1 Exceeding the withdrawal thresholds may have a negative impact on future income payments. Age restrictions and other conditions may apply.
2 Includes Systematic Withdrawal Plans (SWPs) from these categories.
3 GIA refers to insurance company Guaranteed Interest Accounts.
4 Fees may apply.
5 Some products may provide greater flexibility.

Risks and goals in retirement 

With Canadians facing many challenges as they transition into retirement, the traditional financial planning and investment strategies such as asset allocation may no longer be enough to protect assets and ensure a sustainable retirement income stream, especially during volatile market conditions. Below are some of the potential risks that retirees may face. 

Inflation risk 

Inflation over the long term can significantly erode buying power. For example, in the table below you can see that in 30 years, the buying power would be reduced by nearly 60 per cent, assuming a 3 per cent inflation rate. 

Effects of inflation on $1,000 

Number of years	0% ($)	1% ($)	2% ($)	3% ($)	4% ($)
1	1,000	990	980	970	962
10	1,000	905	820	739	676
20	1,000	820	673	545	456
30	1,000	742	552	402	308

Market volatility 

During retirement, an investor’s rate of withdrawal and the order or sequence that they earn their market returns can have a dramatic impact on their portfolio’s ability to last. For example, if an investor experiences poor market returns early in retirement, this may have a dramatic impact on how much income they can continue to receive or how long it will last. 

Longevity risk 

Compared to previous generations, both male and female Canadians can expect to live longer lives and could spend as much time in retirement as they did working. 

The probability of a healthy 65-year-old living until… 

Age	Single female (%)	Single male (%)	At least one of a male and female couple who are the same age (%)
70	96	95	99
80	82	77	96
90	47	38	67
95	25	17	37

Source: 2012 IAM Basic ANB Tables, Society of Actuaries. For illustration purposes only. 

Why the sequence of returns matters 

Sequence of returns means the risk of receiving lower or negative returns early in a period when withdrawals are made from the underlying investments. The order or the sequence of investment returns is a primary concern for those individuals who are retired and living off the income and capital of their investments. 

During the accumulation phase, regardless of whether a portfolio experiences poor or strong returns early on, the market value will be the same in the end. 

Accumulation phase 

Starting value for Portfolio A and Portfolio B = $200,000 Annual income withdrawal = None 

	Portfolio A Poor early returns		Portfolio B Strong early returns
Age	Annual return (%)	Year-end value ($)	Annual return (%)	Year-end value ($)
40	–	200,000	–	200,000
41	-5.3	189,400	15.3	230,600
42	-2.1	185,423	-3.7	222,068
43	-7.3	171,887	14.0	253,157
44	-15.2	145,760	8.9	275,688
45	9.4	159,461	16.0	319,798
46	2.7	163,767	15.2	368,408
47	10.6	181,126	16.2	428,090
48	-9.8	163,376	13.5	485,882
49	-8.0	150,306	0.4	487,825
50	10.2	165,637	12.9	550,755
51	6.9	177,066	13.4	624,556
52	-5.5	167,327	9.5	683,889
53	2.1	170,841	13.5	776,214
54	2.4	174,941	6.0	822,787
55	9.2	191,036	-1.5	810,445
56	-1.5	188,170	9.2	885,006
57	6.0	199,461	2.4	906,246
58	13.5	226,388	2.1	925,277
59	9.5	247,895	-5.5	874,387
60	13.4	281,112	6.9	934,720
61	12.9	317,376	10.2	1,030,061
62	0.4	318,645	-8.0	947,656
63	13.5	361,663	-9.8	854,786
64	16.2	420,252	10.6	945,393
65	15.2	484,130	2.7	970,919
66	16.0	561,591	9.4	1,062,185
67	8.9	611,573	-15.2	900,733
68	14.0	697,193	-7.3	834,980
69	-3.7	671,397	-2.1	817,445
70	15.3	774,120	-5.3	774,120
Avg.	4.6	774,120	4.6	774,120
		No Difference

A portfolio that experiences poor early returns can run out of money during retirement, whereas a portfolio experiencing strong early returns can last for many more years and maintain a high market value. This illustrates how the Sequence of Returns in those crucial first years can produce two very different outcomes. 

In the chart below we look at two portfolios. Portfolio A has poor early returns and runs out of money within 17 years. Portfolio B experiences strong early returns, has 13 more years of withdrawals and still has a positive market value at age 95. 

Retirement phase 

Starting value for Portfolio A and Portfolio B = $500,000 Annual income withdrawals = $20,000 (4% of first-year value) adjusted thereafter for inflation. Inflation rate = 3% 

	Portfolio A  Poor early returns			Portfolio B  Strong early returns
Age	Annual return (%)	Withdrawal ($)	Year-end value ($)	Annual return (%)	Withdrawal ($)	Year-end value ($)
65	–	–	500,000	–	–	500,000
66	-5.3	20,000	454,560	15.3	20,000	553,440
67	-2.1	20,600	424,847	-3.7	20,600	513,125
68	-7.3	21,218	374,164	14.0	21,218	560,774
69	-15.2	21,855	298,758	8.9	21,855	586,883
70	9.4	22,510	302,216	16.0	22,510	654,673
▼	▼	▼
80	9.2	30,252	58,386	-1.5	30,252	1,245,891
81	-1.5	31,159	26,818	9.2	31,159	1,326,487
82	6.0	26,818	0	2.4	32,094	1,325,458
83	13.5	0	0	2.1	33,057	1,319,542
84	9.5	0	0	-5.5	34,049	1,214,791
85	13.4	0	0	6.9	35,070	1,261,122
▼	▼	▼
90	15.2	0	0	2.7	40,656	1,111,520
91	16.0	0	0	9.4	41,876	1,170,191
92	8.9	0	0	-15.2	43,132	955,746
93	14.0	0	0	-7.3	44,426	844,794
94	-3.7	0	0	-2.1	45,759	782,256
95	15.3	0	0	-5.3	47,131	696,163
Avg.	4.6	429,956	0	4.6	951,508	696,163
			Big Difference
Total income generated by portfolio during retirement =			$429,956		$951,508
Difference in withdrawals			$521,552
Difference in end value			$696,163
Total difference			$1,217,715

For illustration purposes only. Returns for Portfolio A are hypothetical returns, and not indicative of future performance. It does not include any fees or Management Expense Ratios (MERs). For Portfolio B, the returns are reversed. The sequence of returns has an average compounded annualized return of 4.6 per cent over the respective periods. The accumulation portfolios assume a starting value of $200,000 at age 40 with no annual withdrawals. The retirement portfolios assume a starting value of $500,000 at age 65 as well as a four per cent first-year withdrawal, thereafter adjusted for three per cent inflation annually. 

Cash wedge strategy 

Market volatility can be both an investor’s friend and foe. For the long-term investor, a stumbling market presents an opportunity to buy stocks at reduced prices. But this doesn't work for an investor with immediate cash needs, such as retirees drawing an income. If the market drops early in their retirement, it can make a significant dent in their retirement income. 

The cash wedge strategy is designed to help mitigate the impact of volatility on your client’s retirement income. It’s a way of organizing their wealth so that the assets they draw income from — a cash wedge representing one, two, or three years of income — is invested in stable-short term investments. The remaining money can be invested in funds selected to capture the growth potential that's associated with market-based investing, with any gains realized used to replenish their income source — your cash wedge. 

How does the cash wedge strategy work? 

Typical asset allocation for a balance-oriented investor 

Did you know?

GIAs have the potential to help with creditor protection during the investor’s lifetime, as well as after death when the death benefit passes directly to a named beneficiary outside the estate. It is very important to consult with a legal advisor to discuss the rules surrounding eligibility for creditor protection. 

Tax treatment of investment income 

Income from investments is included in taxable income at different rates. Active management of income-generating investments can significantly affect the way income is taxed and may help reduce clawbacks. 

Chart 1: Consider the after-tax income on $10,000 

Source of income	Inclusion rate (%)	Income reported on tax return ($)	Tax payable ($)	After-tax income ($) (MTR 40%)
Eligible dividends	138	13,800	2,500	7,500
GIC/bond/RRIF/salary	100	10,000	4,000	6,000
Capital gains	50	5,000	2,000	8,000
Mutual/Segregated fund withdrawals	2.5	250	100	9,900
Series T mutual fund	0	–	–	10,000

The above chart illustrates how $10,000 of income, from different sources, is reported on a tax return and how much is remaining after tax. 

Dividends 

Dividends received from Canadian corporations receive preferential tax treatment through the application of the dividend tax credit. However, dividend income is the least income-friendly since only the grossed-up amount is reflected on the tax return, which is used to determine eligibility for many income-tested benefits such as Old Age Security (OAS). Dividends paid by public corporations qualify as ‘eligible dividends’ and are included at 138 per cent. Non-eligible dividends are included at 115 per cent. For illustration purposes, an effective tax rate of 25 per cent is assumed in the above chart – although it will vary by province.

Mutual/Segregated fund withdrawals 

From an income-inclusion perspective, receiving income in this manner is income friendly since only a small portion of the income stream is taxable as a capital gain; the balance will be non-taxable Return of Capital (ROC). Chart 1 assumes $200,000 invested, five per cent annual rate of return ($10,000) and mutual/segregated fund withdrawals of $10,000. It represents results for year one and does not consider year-end distributions or allocations.

Series T mutual fund 

Series T funds are a special class of mutual fund designed to help create a tax-efficient income stream from investments in non‑registered accounts, while allowing the deferral of capital ­­gains taxes until a later point. ROC levels will fluctuate based on the level of income earned and distributed by the fund, as well as availability of the original capital. Illustration assumes 100 per cent ROC and no year-end distributions.

Withdrawal from investment funds – how to calculate the tax 

At the time of each withdrawal, there is a sale of units to fund the withdrawal. This sale will trigger a capital gain or loss. To determine the amount of the capital gain or loss, one must look at the Adjusted Cost Base (ACB) and the growth/loss (Fair Market Value − ACB). 

This diagram illustrates how to calculate the capital gain and the return of capital. In this example, the growth represents 1/21 ($10,000/$210,000) or 4.76% of the total Fair Market Value (FMV) and the return of capital represents 20/21 ($200,000/$210,000) or 95.24% of the FMV. Therefore, 1/21 (or 4.76 cents) of each dollar realized because of a redemption will be considered a capital gain (of which only 50% is taxable) and 20/21 (or 95.24 cents) of each dollar will be considered a return of capital (which is not taxable but reduces the ACB). The calculations will depend on the growth/loss and ACB at the time of withdrawal. 

Guaranteed payment phase 

For a product with a guaranteed lifetime income benefit, payments will continue when the FMV is $0 but there is a positive benefit base. The taxation of these payments is not certain at this time. Please consult your tax advisor for further information.