Tax efficient funds offer clients a fixed level of income at a low tax rate. This may be an ideal solution for non-registered investors, but several experts interviewed by The Insurance and Investment Journal recommend that advisors keep a close eye on the sustainability of these monthly distributions.
Tax efficient funds, sometimes called T-class or T-series funds, pay a fixed amount of income to the investor each month. Unlike regular mutual funds, which simply pay out whatever the fund had earned, these funds are structured so that much of the monthly distribution is actually a return of the client's own capital, which means that it is not subject to income tax.
Steven Zanolin, a product specialist at Desjardins Funds, says that the target market for these types of investments is typically non-registered investors who are five to ten years away from retirement. He points out that the fifty plus cohort that are coming close to retirement can accumulate assets in standard A-class funds, make the switch to T-class funds without triggering any tax implications, and start drawing a monthly income.
And how much can a T-class investor expect to receive in distributions? That depends on the type of fund. For example, Desjardins' Dividend Income T-class fund pays 6% a month while its Global All Cap Equity T-class fund pays 8% a month.
Data collected by the Toronto research firm Investor Economics shows that the product category steadily gained over the last few years. Between December 2002 and December 2008, assets under management grew from $0.7 billion to $10.7 billion, with a compound annual growth rate of 95% between 2004 and 2008. Last year, however, was not quite so rosy.
"2008 and 2009 were difficult and the inflows were pretty much flat," comments Mr. Zanolin. "We had a lot of clients who were migrating to traditional savings products, namely GICs. Given the situation [in the markets], that was no surprise." But Mr. Zanolin notes that growth is picking up again, and he expects the T-series category to account for about 10 to 15% of assets under management by the summer of 2010.
Jeff Ray, Assistant Vice President of mutual fund products at Manulife Financial says that his firm has also experienced a fairly modest rate of growth recently. "This is likely as a result of market volatility that has caused numerous investors to seek alternative investments," he says. "For instance, we continue to see strong interest in our guaranteed products, such as insured GICs and segregated funds."
Fund companies are promoting the tax advantages of these funds, but Kurt Rosentreter, a Chartered Accountant, Certified Financial Planner and senior financial advisor with Manulife Securities, warns that there is no free lunch. "At the end of the day, it's a trade off," he says. "You may be avoiding the taxes now while the fund is grinding down the cost base, but you could end up paying taxes later. Now tax deferral is generally a good thing, but the decision on whether you should buy in the first place needs to be based on fundamentals. Advisors need to educate the investor about how these products really work. There may not be taxes now, but they could face them when they sell or die."
Dan Hallett, a Chartered Financial Analyst, Certified Financial Planner, and Director of asset management at HighView Financial in Oakville, Ontario, is also skeptical of the tax advantages. "The so-called tax benefit of T-series comes very simply from the fact that the fund pays out an amount of cash that exceeds its taxable income."
He points out that both T-class and A-class units are separate parts of a single legal entity, and that the fund's total taxable income is allocated equitably across the two categories. "The tax deferral is mythical when you break it down," he notes. "T-series units don't avoid the allocation of its share of the total fund's taxable income."
For example, a T-series fund might pay $1 per unit in cash when only $0.20 of that is taxable income. The regular A-series units just pay out the $0.20. "Investors in both funds get the same tax bill, but T-series investors get more cash," says Mr. Hallett.
Instead of opting for the fixed distribution level offered by T-series, he says it's just as easy for advisors to set up clients with their own systematic withdrawal plans and only withdraw the exact amount cash they need by selling units. Since the investor is actually liquidating units rather than blindly taking the pre-established amount from a T-class fund, Mr. Hallett suggests the client will be more likely to pay attention to the true sustainability of his or her withdrawal plan.
"The sustainability of the cash flow is predicated on successful investing," says Mr. Rosentreter. "There's an element of risk here that should not be overlooked. Of course right now nobody wants to buy a 1% bond, but the advisor needs to dig down and get a solid answer about what the fund managers are buying. If a fund is promising 8% or 10% distributions, it's not all going to be BCE or Manitoba Tel. My advice is to be careful and go slow.
So how do fund companies set their distribution levels to make sure they are sustainable? Mr. Zanolin says that that Desjardins uses median return expectations as reported in Watson Wyatt's (now Towers Watson) survey of more than 40 professional money managers as well as input from their own individual fund managers to decide on target distribution rates. "They are monitored on a quarterly basis, but we do not reset them, as most of our competitors do, every year," he says. "We reset as needed." The last time Desjardins had to reduce a distribution on a T-class fund was in March 2009. "But at this juncture, there is not a concern," says Mr. Zanolin.
Mr. Ray of Manulife says that if a fund doesn't have enough cash on hand to fund distributions, it could be forced to sell off investments. "This can be an issue if the portfolio manager has to sell positions he or she would rather hold for a longer period and can also result in higher than expected trading costs charged to the fund," he says. "This is mitigated by the fact that we monitor cash levels in our T-series on a very regular basis to ensure this issue doesn't arise."
White lies and leverage
"Maintaining the distribution rate in the absence of fresh cash would typically require liquidation of some portion of the portfolio, and that would typically result in a capital gains liability to the unitholder, comments Norbert Schlenker, a Chartered Financial Analyst, Certified Financial Planner, and fee-only advisor in British Columbia. Recent market movements may have delayed this process, he says, as many portfolios could have realized substantial losses between October 2008 and March 2009 and may be carrying them forward to shelter more recent gains. "But that dodge is likely coming to an end."
Mr. Schlenker believes that there is a very large group of investors who can be fooled into believing that cash in hand is the same as income earned. "These products, among others, are tailored to appeal to this group," he comments. He doesn't think advisors should be selling T-class funds at all, but he does admit that there are some clients who must encroach on capital to fund their lifestyles and have a psychological aversion to dipping into it overtly.
"T-class funds are a way of getting over that hump for these clients, a white lie," he says. "A white lie is still a lie, mind you, and advisors shouldn't fool themselves." If an advisor must use a T-class fund, he says they should look for low fees and, if possible, capital loss "carry-forwards" inside the portfolio.
For his part, Mr. Rosentreter also warns against using T-class funds in leveraged investment strategies. "I've heard of people borrowing $200,000 against their homes and then investing in high income T-class funds," he says. The idea is that the plan would be able to fund itself, as the loan payments are paid from the fund's cash flow.
"When I meet with a prospect who has opted for this kind of strategy, I say that what they've been told is correct based on current distributions, and that so long as markets keep performing, they are probably going to be fine. But what about the worst-case scenario? What if distributions have to change?"