In the past, mutual fund companies like AIM Trimark and Franklin Templeton used to promote the merits of a Systematic Withdrawal Plan (SWP) for investors who wanted to create income from their mutual funds.
What is a SWP?
A SWP is simply using a mutual fund and arbitrarily determining a dollar amount of monthly income. Every month, the mutual fund company sells enough units to create that specified amount of income.
Let's go through an example. Let's assume you invest $100,000 of capital and that you want a 10% income yield. This would mean that we would get paid $10,000 per year or $833.33 per month.
If the mutual fund earns 10% then theoretically your $100,000 capital should stay intact. If you earn 12% then your portfolio will grow and if you earn less than 10% your capital will drop. Historically, the Templeton Growth Fund has a 15-year return of 9.4% compounded and the Trimark Fund has the best 15-year return of any global equity fund with a 13.0% compounded return.
A new kid in town
In the mutual fund industry there are now specific funds designed to create income for investors. Instead of having to specify the amount of income investors want and then arranging for the systematic liquidation of units, many mutual fund companies have created products that do all the work for you.
An example of this type of fund is the Clarington Canadian Income Fund. The Clarington Canadian Income Fund pays out a fixed distribution of 6 cents per unit on a monthly basis. At December 31, 2003, the Clarington Canadian Income fund was $8.23. An investor who put in $100,000 on December 31, 2003 would have gotten 12,150.67 units. Based on a 6 cents distribution per month, this investor would receive $729.04 per month or $8,748.48 over the course of a year. That translates to an 8.75% income yield.
The Clarington Canadian Income Fund is simply a balanced portfolio of stocks and bonds. If the manager were able to outperform the 8.75% then the investor would have more than $100,000 at the end of the year. If the manager under performed the yield, then the investor would have less than $100,000. In the end, the monthly income remains the same regardless of the fluctuation in price.
Today, there are many other income funds that invest in a variety of different investments. Dividend Funds, Income Trusts, and Bonds are the most common types of income funds.
Differentiating between yield and return
When investing in income funds, it is so important to recognize the difference between income yield and rate of return. The income yield is simply the amount of monthly income that is generated on the investment. Far too often, investors chase after the highest yield thinking that it is the best return on their money. The reality is the yield is set by the mutual fund company at their discretion. However, income funds that set their yields too high risk depleting capital. Remember that if a mutual fund has a yield of 10% but the return is only 8%, then the capital will be depleting to the tune of 2%.
The main priority of income funds is to provide stable, tax efficient income. Managers know that people who buy these funds are looking for regular cashflow.
The second priority is generally to preserve the capital while maintaining the income. Many of these income funds target yields ranging from 4% to 10% depending on what they are investing in. The higher the yield, the greater the risk is of depleting capital.
Finally, the third priority is capital appreciation. One general rule of thumb to live by is funds with a higher yield are less likely to grow capital. If you are hoping for capital appreciation, you might want to look for a fund with a lower yield.
Despite all these priorities, remember there are no guarantees. Income can change, capital can deplete and values can drop.
With a SWP, it is the investors' responsibility to report the purchase and disposition of units and also to calculate the changing adjusted cost base of the fund. This can be somewhat complicated, confusing and daunting to the average investor.
At the end of the year, they report everything you have to report on your tax returns in the form of a T3 or T5. Many income mutual funds get creative in tax efficiency by reporting return of capital, which means that you defer capital gains income into the future.
My two cents
They can be used for non-RRSP money but they can also be used for RRIFs. Try not to get too caught up in the yield and focus more on buying good quality funds that focus on tax efficiency.