Q: I am a widow with $300,000. How realistic is it for me to realize 4% a year for the next 20 years without touching my initial investment? I will need $12,000 a year to supplement my Social Security and small pension I have.
Are there types of investments that would be best for this type of return and risk to realize my goal?
A: I’ll try to address a few of the considerations here, LM.
For one, it sounds like you need $12,000 after-tax. If you have modest pension income, depending on your province of residence, you could be paying anywhere from 0-25% tax, let’s say, on your investment income. I’m throwing out a very general range because it really depends on how “small” your pension is, any tax deductions or credits you may be eligible to claim, etc.
The point is, if you’re paying, say, 25% tax on your investment income, you may need $16,000 of pre-tax income to achieve your goal of $12,000 after-tax with principal protection.
Different sources of income are taxable at different rates, LM. Canadian dividends may be tax-free at $25,000 of income, for example, while interest may be taxable at 25% (again, depends on your province of residence, tax deductions and tax credits).
Furthermore, if you need $12,000 per year now, presumably that will rise over time with inflation. That is, the $12,000 per year you’d be spending now on goods and services will increase with the cost of living.
The Bank of Canada targets inflation of 2% and Canadian inflation has been 1.88% over the past 20 years and 2.14% over the past 30 years.
It may be hard to find an investment that will generate $12,000 per year with no volatility and have that $12,000 rise each year with inflation.
One thing I would question, LM, is why you want to preserve your investment capital? For some people, it’s an emotional thing. Or perhaps it’s an amount that you feel you want to leave to your beneficiaries? That’s a personal choice and I respect that.
But I feel it’s worth pointing out that if you could invest $300,000 at 4% per year for 20 years, you could withdraw $21,226 per year and draw the account down to zero after 20 years. Or $17,926 per year indexed at 2% annually for 20 years.
It’s tough to find a 4% risk-free return right now, LM. The best five-year Guaranteed Investment Certificate (GIC) rate I could find today was 3.52%. That’s close. But as mentioned, interest is taxed at a higher rate than Canadian dividends, which may be tax-free for you. That means you would need well over 4% from a GIC to be left with 4% after-tax. It may be a few years before we see 5%+ GIC rates.
Preferred shares are a type of fixed income investment (like a bond) that are generally issued by banks, pipelines, utility companies and similar businesses. Unlike common shares, they don’t go up and down in value the same way. They pay Canadian dividends and although they are fairly stable, they’re definitely not GICs. They can fluctuate in value despite the steady income stream.
The Solactive Laddered Canadian Preferred Share Index, for example, pays about a 4.12% dividend right now, which may very well be tax-free to you. Buying preferred shares has a cost though, whether you buy individual preferred shares, an exchange-traded fund (ETF) or a mutual fund. And again, LM, you’re trading tax efficiency for volatility (the index was down 20% in 2015, for example, albeit temporarily).
There are several high yielding dividend paying common shares included in the S&P/TSX 60 index. 13 of the 60 pay dividends of more than 4% currently. The dividends are tax efficient, possibly tax-free for you, and they tend to grow over time, providing inflation protection. But again, you have the volatility problem. The index was down 31% in 2008.
A balanced portfolio including GICs, bonds, preferred shares, Canadian / U.S. / international common shares may very well help you achieve your 4% annual return target over the next 20 years, LM, if you have a decent stock exposure. It would also depend on the fees paid (presumably, this isn’t something you’ll do on your own and you’ll use an advisor of sorts). But stocks, by their very nature, go up and down. You’d have to be willing to put your capital at some risk in the short-term to earn 4% in the long-term without depleting your capital.
Finally, another option to consider is an annuity. With an annuity, you give a lump-sum of money to an insurance company and they pay you an income for the rest of your life. If we assuming you’re 70 years old, you could buy an annuity of $19,980 per year with $300,000. If you wanted to guarantee 20 years of payments, even if you died before the 20 years had elapsed, your payments would be only $18,029. If your capital preservation goal was just so you didn’t have to deal with volatility, an annuity eliminates all volatility implicitly.
The point is, LM, there are a few different ways to achieve your goals. I’d start with clarifying how important the capital preservation component is first and foremost. Then determine the tax implications of different forms of income based on your current income, deductions and credits. Then you’ll have to decide whether GICs or an annuity (no risk) are more appealing than a balanced investment portfolio (some risk, but a higher return / income). Good luck.
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.
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