How To Turn Your Investments Into A Pay Cheque In Retirement
Workers who have defined benefit pensions have it much easier when it comes to replacing their incomes in retirement, especially if they were plan members for many years. They can continue to receive a pay cheque based on a pre-determined pension formula. Some pensions are even increased each January based on an inflation adjustment.
Retirees with some or all of their retirement income funded by their investments have a little more work to do. Here are a few tips on how to turn your investments into a pay cheque when you retire.
Prioritizing Accounts
The natural inclination of many retirees is to minimize tax, and that includes deferring withdrawals from registered accounts like Registered Retirement Savings Plans (RRSPs) until age 72.
An RRSP accountholder can withdraw from their RRSP at any age, though. Taking early withdrawals may result in less lifetime tax than deferring withdrawals, especially if a retiree is not in a high tax bracket early in retirement. Converting an RRSP to a Registered Retirement Income Fund (RRIF) may also allow a retiree to split income with their spouse and benefit from a pension income amount tax credit that reduces the tax on their withdrawals.
If a retiree with an RRSP has multiple accounts, particularly a non-registered account, it might be easiest to take monthly withdrawals from their non-registered account. Then, an RRSP or RRIF withdrawal can be taken once a year in November or December to maximize tax-deferred growth in that year, more accurately estimate and plan their income for the year at year-end, and only worry about a single annual withdrawal from that particular account. The RRSP or RRIF withdrawal could then replenish the non-registered account funding the monthly withdrawals for the year ahead.
Obviously, if a retiree has only an RRSP/RRIF account, it can make things easier. But some retirees have multiple types of registered accounts, corporate assets, and various other sources to consider.
Tax and decumulation strategy can be complex, but our goal is to focus on investment management for a retiree drawing down their savings.
Live Off Your Investment Income
Some retirees focus on buying investments with a high dividend yield to avoid having to sell investments or draw down their capital. If an investor sticks with blue-chip Canadian stocks, the problem with this approach is they may end up with a portfolio focused on a narrow sector allocation. Generally, this includes banks, utilities, and telecom stocks.
Utility stocks make up 2.4% of the S&P 500 as of November 30, 2023. Banks and telecommunications represent only a portion of the Financials and Communication Services sectors, which account for 12.9% and 8.6% of the index, respectively. As a result, a high-dividend Canadian portfolio could have very little geographical diversification and represent less than one-quarter of a well-diversified index like the S&P 500. Sectors like technology, health care, industrials, and consumer stocks, amongst others, could be overlooked.
Striving for yield beyond blue chip stocks could cause investors to opt for riskier stocks with high distributions they may not be able to maintain.
Striving to live off dividend and interest income may leave a significant inheritance to a retiree’s heirs, which may be a goal, but could also cause the retirees to have a lower standard of living than they could otherwise afford. Even if leaving a legacy is important to a retiree, advancing portions of an inheritance over time when their beneficiaries need it rather than as a lump sum on death may arguably be a better strategy.
Sell Individual Holdings
In order to raise cash for investment withdrawals in retirement, an investor could sell individual holdings. If a portfolio is well-diversified, this might work, but an investor typically needs at least 15 to 25 stocks to have a properly diversified portfolio that minimizes single-company risk.
If a retiree chooses to sell off their losers and keep their winners, they may cause their weightings to get out of line as well by maintaining an increasing allocation to stocks that have done well historically. So, this is something to monitor.
Sell Incrementally
If a retiree could sell all their holdings incrementally to come up with the cash for their monthly withdrawal, this could help them maintain a diversified portfolio. The problem for a stock investor is this may increase transaction costs to sell a small dollar amount of dozens of different holdings.
Mutual Funds Or All-In-One Exchange-Traded Funds (ETF)
Holding asset allocation mutual funds can make it easier to sell down a portfolio, as most mutual funds have no fees to sell. Stocks, on the other hand, may have a $5 to $10 transaction fee at a discount brokerage and can vary when working with an investment advisor.
An all-in-one or asset allocation ETF held in a portfolio that is being decumulated may help the drawdown process. You can easily sell $5,000 of a diversified ETF at a low cost, with minimal effort, and possibly not have to rebalance any other investments.
Fixed Income Ladder
Building a Guaranteed Investment Certificate (GIC) or bond ladder can help fund withdrawals in retirement. An investor can hold many fixed-income products with different maturities. As an example, an investor could hold a 1-year, 2-year, 3-year, 4-year, and 5-year GIC with face values equal to the anticipated account withdrawals or at least a portion of those withdrawals. You can buy longer-term GICs or bonds and build out a pretty predictable maturity schedule that can be used to top up an account that is funding withdrawals.
Now that interest rates are higher, this is a much more appealing option than it has been in many years.
Annuity
As interest rates have risen, the appeal of annuities has also increased. An investor can buy an annuity from an insurance company by handing over their savings in exchange for a monthly payment. The payment is dependent on their age, life expectancy, and interest rates.
Annuities have not been popular for many years due to declining interest rates. Investors may also have a psychological impediment that makes them hesitate to hand over their savings. Oddly, the defined benefit pension plans that so many without a pension covet involve the same process. Payroll contributions are made to the pension plan to buy a future monthly payment. Non-pensioners can do the same with a lump sum payment to an insurance company, but few are willing to do it.
Annuities may be inflexible with no upside potential, so a savvy stock investor may be less inclined than a less knowledgeable, conservative investor to consider annuities.
Canada Pension Plan (CPP)/Old Age Security (OAS) Deferral
Deferral of government pensions may be the easiest way to simplify your retirement income. This is because of a few key factors, namely:
- The increase in CPP and OAS pensions for each year of deferral after 65 is quite high at 8.4% and 7.2%, respectively, through age 70 plus the annual inflation adjustment.
- Because CPP and OAS are inflation-adjusted pensions, the higher they are, the more protection retirees have against high inflation in retirement impeding their ability to keep pace with the cost of living.
- Investments can be drawn down earlier in retirement when investment and other financial decisions could be easier to make, while more retirement income will be funded by simple, guaranteed sources like CPP and OAS in a retiree’s later years when a cognitive impairment or lower risk tolerance is more likely.
A healthy retiree is more likely to benefit from CPP and OAS deferral because a pensioner may need to live into their mid-80s to come out ahead and collect more pension income after considering the time value of money. An unhealthy retiree whose life expectancy could be shorter may want to start their CPP as early as 60 and their OAS as early as 65.
Summary
Tax and pension strategy is a key part of retirement decumulation. When it comes to the investment management component of taking regular withdrawals from your accounts, there can be techniques to make the drawdown easier.
Retirees who work with an advisor should be leveraging their expertise and working with them to figure out a strategy for funding regular bank account deposits. Self-directed investors may have a little more work to do, but that is part of the trade-off to have lower investment fees.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.