Create a Fixed Income, Don’t Confuse Return with Revenue?

One of the goals of this blog is to help people feel comfortable in saving for retirement.  I am convinced that if the mystery of accumulating a significant nest egg is debunked and how to benefit from your efforts is demonstrated, then most people will just do it.

Today, we look at what you’ll want to consider when planning the point when you can finally stop working, taking your retirement, Yeah!

To do so safely, without risk of returning to the workforce for a lack of revenue, let’s look at how to create a fixed income.

Beforehand, let’s set the scene.  Depending on your age, what stage of the life cycle you are in and your tolerance for risk, your investment choices will differ.  Adding to the complexity of the matter is the extensive menu of products offered by all those trying to sell you something.

The main point here is to save enough money while you are working to replace your income for the duration of your retirement.  Whether you are employed by the government with a generous pension plan or are self-employed with no pension at all, the equation remains the same:

Savings required = annual income during retirement X number of years retired

We covered How To Plan for Retirement recently and today will look at what will happen once retired.

Most people have an idea of what is an acceptable investment return.  After years of experience and watching your retirement savings account statement, you will develop a target return.  For conservative investors the number may be 4-5% for aggressive growth types often the goal is double-digits.  When you approach retirement, there is a different percentage that becomes even more important: how much income do I need to draw from my investments?

I sat with a client last week who illustrated this concern perfectly.  Earlier this year, his broker suggested he replace his income trust units, their mandate will change due to pending legislation, with a balance mutual fund T-unit, to distribute return of capital.  The client authorized the transaction, his needs are simple.  He has been drawing 8% from these income trust units for years.  When he receives his quarterly statements, the value of his investments fluctuate and he can live with this.  You can imagine what happened when he opened his June statement!  The value of his mutual fund dropped by almost 10%.  Not only did he take his 8% income but the return was down almost two percent.  Needless to say, the client was not impressed.  This is why he came to see me for a second opinion.

The client has clear objectives: he wants 8% revenue from his investments and wants his capital to last beyond his life, when his wife will use the revenue.  While it took a discussion of 45 minutes to discover, he was very clear about his needs.  He thought 8% was the return he needed to meet his needs.  Unfortunately, with the volatility in the markets in 2010, finding an investment that will return 8% annually, month after month is not obvious.  What this client is looking for is a fixed income.  Once I explained that it was possible for him to purchase a fixed income that paid 8% annually, he became curious.  It was as if this concept had never been explained.  This is a client who has dealt with several brokers and financial advisors during his 60+ years.

I showed him a Provincial bond with a 17 year maturity date on the secondary markets.  It has an 8% coupon paid semi-annually and has an overall return of 4.42% if held to maturity.  Which brings us to the risks of such an investment.  The return is guaranteed only if the investor holds the product until maturity and if the issuer honours the payments (does not default).  The client was happy to know such a product exists, did not mind paying a premium (paying $142 for the promise of $100 in 17 years + 8% revenue annually) and had other funds set aside for an emergency so he can afford to hold until maturity.

So to recap: a fixed income instrument: bond or debenture is designed to pay a fixed percentage of its value (annually or semi-annually) until its maturity date when the capital (face value) is repaid.  The return of the investment depends on the price paid for the investment.  If you pay more (a premium) for the investment than it is worth at maturity, it’s because you value the revenue.  If you buy it for less (a discount) than its maturity value then it is usually because the revenue is lower than its return.

Please let us know: are you comfortable with the difference between return and revenue?  Are you ready to create a fixed income when the time comes?  Share your questions and comments so we can build on these points in future posts.

Author: Robert