When is income the right choice? Examining income-based investments

Around the water cooler and the dinner party table, the word on many people’s lips is “income.” Over the past two years, sales of income-generating investments – including balanced income funds, dividend funds, income trust funds and bonds – have soared. Yet most of the investors driving this growth reinvest their distributions, which means they aren’t buying income investments to receive the benefit of an income stream. Nevertheless, “collective wisdom” seems to suggest that everyone should be concentrating their assets in income.

Of course, collective wisdom has been wrong in the past. Put yourself back six years to the heady days before the crash in technology stock prices. At that time, investors who were underexposed to the technology sector were accused of missing the boat. Yet those who stayed true to their investment objectives fared best through the cycle.

The same principle applies today. It’s much more important to hold a mix of assets that matches your specific needs than to jump on the latest investing bandwagon. Your goal should always be to assemble a portfolio of puzzle pieces, each of which works well with the others. It’s also critical to pay attention to details that may not at first seem important, such as the tax consequences of investing in investments that generate income.

With that in mind, the following case studies highlight situations where investors might consider investing in income and some of the factors they should take into account before making their decision. Discuss the case studies with your financial advisor and then, together, determine how much income belongs in your portfolio.

Choosing income for long-term growth
Bob is 40 years old and works in the provincial civil service. He is at least 20 years away from retirement and doesn’t need an income stream at this time. However, he has managed to accumulate $100,000 in a non-registered account and, in a meeting with his advisor, he mentions that he is considering moving 75 per cent of those assets – or a total of $75,000 – into an income trust fund. He explains that, based on what he has heard recently about the strong performance of income trusts, he believes this asset class could deliver the long-term growth he wants for his nest egg.

Bob’s advisor agrees with him in principle, but points out that investing in an income trust fund in a non-registered account will have a tax impact. Even if Bob reinvests the distributions his fund earns, he may have to pay tax each year on dividends, capital gains and interest income. Still, as long as Bob recognizes that he is not making this investment for its traditional purpose – to draw an income – he can benefit from potential long-term returns in an income trust fund.

But Bob’s advisor suggests an alternative strategy that uses the same logic. Instead of moving 75 per cent of his non-registered assets into an income trust fund, Bob could invest the majority of his non-registered portfolio in a mix of Canadian and international equity funds, which have the potential to generate long-term growth and taxfavoured capital gains in his non-registered account. Then he could invest a smaller portion of his account in an income trust fund for the valuable diversification he is looking for.

Bob’s advisor also points out that if Bob wants to take advantage of the benefits of income trusts, he may consider the investment for his Registered Retirement Savings Plan (RRSP), since this will shelter him from the tax consequences of the investment.

Aware of his options, Bob decides to go ahead and purchase some units in an income trust fund within his RRSP rather than in his non-registered portfolio.

He also diversifies part of his portfolio into Canadian and international equity funds as his advisor recommends.

Supplemental income for a student
Carol and Dave’s son, Andy, is heading off to university in two years. Andy’s tuition fees will be covered by a Registered Education Savings Plan (RESP) his parents started just after he was born, but they want to make sure that their own retirement savings have the capacity to generate some income to supplement Andy’s living expenses if he needs their help. When Carol and Dave visit their financial advisor, they are leaning towards investing a lump sum in Canadian bonds because some friends have been pleased with the performance of bonds as an asset class.

Their advisor explains to them that this may actually be a perfect opportunity to consider a welldiversified portfolio of various types of income-generating funds, including bond funds, dividend funds and income trust funds. Diversification will help keep their income stream relatively stable so they have a steady flow of money available to send to Andy if necessary. Also, they can benefit from the added frequency of monthly or quarterly distributions, rather than the semiannual interest payments associated with Government of Canada bonds.

Selecting an income stream
Jane and John are both 55 years old and are hoping to take an early retirement. They have saved $300,000 in their RRSPs, another $50,000 in equity funds in non-registered accounts, and have completely paid off the mortgage on their home. They know they will need some additional income after they stop working to top up their pensions, but they don’t want to start drawing down their RRSPs right away. They arrive in their advisor’s office with no real idea about which strategy will work best for their non-registered account.

Their advisor describes two different scenarios that may work well. The first hold income trusts or a combination of dividend-paying equities. These funds should continue to enjoy growth over the long term, while providing a stream of income or dividends that Jane and John can access during their retirement. The downside is that the income stream is unpredictable. Furthermore, Jane and John will have to sell some of their existing long-term holdings – and they may not be making the sale at the best possible time.

The second strategy, which is the one the advisor recommends for them, is to remain invested in equity funds for maximum potential growth and to set up a Systematic Withdrawal Plan (SWP) to draw money gradually out of their account. This approach can provide significant tax advantages because Jane and John will be paying tax on the capital gains earned by the equity funds instead of on either interest income or dividends, both of which are taxed at a higher rate. And because they will be selling their holdings over a long period of time instead of all at once, they don’t have to try to predict the markets and select the most advantageous time to sell.

Identify your priorities
As you work with your financial advisor to decide how to allocate your portfolio, make sure you have clearly identified your priorities. If you, like Bob, want to use income-generating investments for long-term growth in part of your portfolio, that’s fine as long as you understand that you will be reinvesting your distributions and accept the short-term tax consequences outside a registered plan. If instead, like Carol and Dave, you are looking for a relatively steady stream of supplemental income, a diversified mix of different incomegenerating investments may be preferable. Even if, like Jane and John, you require an income stream, remember that income-generating products aren’t the only solution. Sometimes, equities for continued growth combined with a Systematic Withdrawal Plan are the better choice.

The bottom line is that balanced income funds, dividend funds, income trust funds and bonds should play a role in many different types of portfolios – but always make sure you’re buying them for the right reasons.