I recently met with a lovely couple in their 60’s wanting a second opinion on their investments. Their situation is another case where a financial advisor does not really understand investing for income in retirement. Investing in retirement is different than investing for retirement.
Ben is 67 and Heather is 62. Ben is retired and less than 2 years ago, he transferred his Defined Contribution Pension into a Locked in Retirement Account (LIRA) with his financial advisor. $400,000 went from a lower fee DC Pension into high fee mutual funds. Not only were these high MER mutual funds but they also went in on a back end load, which is not ideal for income investing.
Back end loads are great for the advisor because in this case, he got an up front one-time commission of around $15,000 in addition to his monthly trailers. But how does this compensation help the client? Back end loads or deferred sales charges (DSC) can be restrictive when drawing income from investments because you can only take out up to the 10% free amounts without penalties.
The real problem here was not just the back end load and the compensation to the advisor. The real problem was there were some fundamental flaws in the portfolio construction.
Too many equities.
The portfolio had 10 different mutual funds. There were 6 equity funds, 3 balanced funds and 1 bond fund. The portfolio had 25% fixed income and 75% equities. This portfolio may have been great for a 45 year old getting ready to retire in 10 or 15 years but Ben was 65 at the time and getting ready to draw income.
If we turn the clock back in time, Ben was retiring and just after the money was transferred from the Pension at work to the LIRA, the markets took a turn downward and he immediately saw losses in the portfolio because of his high exposure to the stock market. His $400,000 was now worth $350,000 and he has not taken one cent of income. Because there was too much risk in the portfolio, Ben decided to do what most retirees would do in this situation . . . delay income until the market recovered.
Selling units for income makes for bad math
Let’s just imagine Ben was not in a financial position to delay income. His plan was to transfer the LIRA to a Life Income Fund (LIF) and take $20,000 per year from the LIF. If he took the $20,000 from the LIF, the $350,000 would now be worth only $330,000 and even if the markets bounced back, there would be less money and fewer units, which makes it even tougher to recover from market losses. The $330,000 now has to make over 21% just to recover back to the original $400,000.
Related article: Variable returns can work against you in retirement
Income portfolios need some cash
I can accept that some people will need to have some equities in a portfolio even in retirement to deal with inflation and longevity but the variability of stock market returns is also problematic for creating and sustaining retirement income especially when selling units to create income.
One of the best strategies when it comes to setting up income portfolios is to make sure you have a cash component that is segregated from the equities. This helps alleviate the risk of bad timing.
Ben has 25% exposure to fixed income investments which is $100,0000. Surely, this should be able to generate $20,000 of income without having to touch the equity portion of the portfolio. Here’s the problem. Most of the bonds were in balanced funds and accessing the bonds without selling the stocks was impossible. There was only $10,000 invested directly in bonds.
Balanced funds are very popular investments because they diversify among the three main asset classes but when investing for income, it’s better to segregate the parts.
Related article: Creating income with buckets of money
In Ben’s case, it would be better to have $100,000 invested directly into cash and bonds and the other $300,000 invested in equities. In fact, my preference would be to have $60,000 invested in cash or money markets which guarantees the ability to create at least 3 years of income. Then, Ben should have $100,000 invested into bonds and the remaining $240,000 could be invested in equities. In fact, Ben should consider dividend paying equities to continue having money added to cash. In this case, Ben would have more of a 60/40 split with 60% in stocks and 40% in fixed income which is better suited for an income portfolio producing a 5% income.
The biggest problem of all
No plan! This advisor sold these funds on a DSC basis. We can assume the advisor made $12,000 to $15,000 of compensation plus his annual trailer fees of $1600 per year. Ben and Heather were not aware of the $12,000 to $15,000 commission cheque.
Ben and Heather also have $300,000 in RRSPs and TFSAs with the advisor. That’s $700,000 invested in retail mutual funds. At an average MER of 2.4%, that’s $16,800 in fees every year. For those kinds of fees, the advisor should be doing some serious retirement income planning considering they could go to a fee only planner and pay less than $2000 for a comprehensive income plan.
Unfortunately, I see this kind of thing a little too often. I can see where advisors need to be compensated for good work but in this case, the client lost and the advisor won. Too many advisors don't really understand that portfolios designed to invest for retirement are not the same as investing in retirement. What do you think?