Low interest rates and demographics are all contributing to the collective demand for income-producing products. Tax efficient mutual funds often called T-series funds are benefitting greatly from the trend, so much so that in recent years when the rest of the product universe hit the skids, assets held in T-series funds barely registered the downturn.
"In 2008 everything went down," says Investor Economics senior consultant, Carlos Cardone. The tax efficient units continued to sell, however, and assets in this pool continued to climb, even as values dropped. In December 2005 roughly $2-billion was invested in T-series funds. By 2007, T-series funds held $8-billion in client assets; in 2008 the funds held $9.8-billion and in 2009 the number reached $10.4-billion. "They kept selling. We couldn’t really identify a major downturn or erosion of the asset base. It would seem that it just kept growing."
It’s true there are a lot of clients reaching that time in their lives when it is appropriate to start drawing income, but practical reasons alone don’t seem to be enough to explain why the T-series funds are so popular. In fact, the psychological appeal may be greater than the instrument’s actual usefulness at times, believes one expert.
Across the board, analysts and mutual fund company representatives told
The Insurance and Investment Journal that there is no reason to invest or switch to T-series shares of a mutual fund, unless the client needs income from their non-registered assets.
T-series units make regular distributions by drawing on invested capital. Although some funds also distribute income and gains, these are generally held back within the fund structure until all of the capital has been distributed. These distributions are "tax effective" because return of capital (RoC) payments are not taxable – in most cases, original contributions were likely made using after-tax cash flow.
After several years, once all of the client’s original capital has been returned, further distributions of the balance (income and capital gains) are taxable as they’re paid out.
In theory, the client won’t be receiving these taxable distributions until retirement when they are hopefully in a lower tax bracket. "If you are retired with millions in your hand," says Mr. Cardone, "it’s not particularly useful." Some clients, though, may opt to donate their shares once they’ve drawn all of the capital from their holdings to get the further benefit of a charitable contribution receipt.
For advisors, and clients working with an advisor, it’s first important "to determine how much cash flow they need on an after-tax basis and take a look at what they already have coming in, whether it be from Old Age Security (OAS), CPP or any other sort of company pension. If there’s a deficiency between what they need and what they’re receiving, that could be made up using their investments." says
Frank DiPietro, director of tax and estate planning at Mackenzie Financial. "I think what clients, and even some advisors need to understand about the T-series, though, is that it’s only used for cash flow. If the clients are going to be reinvesting they do not need to have a T-series fund. Unless the client needs cash flow, you don’t need to use T-series."
Despite this, there is still a lot of evidence clients are buying or switching to T-series units, even inside of their registered accounts – a practice which yields no net benefit.
"I can only think of two reasons for that, although neither of them really makes a lot of investment sense," says
Dan Hallett, vice president and director, asset management at Highview Financial Group. "If they were planning withdrawals, from a RRIF or an RESP, maybe they can draw money from whatever accumulates in cash. The other, frankly, is just how people view funds that are paying out something on a monthly basis."
This highlights the misunderstanding a lot of clients have about T-series funds, oftentimes confusing the distributions with yields or investment returns, rather than understanding that they are simply having their own cash returned to them. Clients and advisors also need to know about the sources they’re drawing from.
"You want to make sure you’re (taking distributions from) an appropriate product and that your returns over time will at least meet or exceed the targeted payout so that you’re not eroding capital too quickly," says
Darren Farkas, vice president of product research at Fidelity Investments Canada. "There are some products where we would only offer five per cent, not eight per cent, depending on our return expectations."
For the advisor, he says deciding whether or not to use T-series funds with clients is "very dependent on the individual’s circumstances, their tax situation and where they have their assets. Generally speaking, it’s more advantageous to draw down non-registered assets, especially in a tax-efficient manner, before you start to draw down your registered assets" in retirement.
Another thing to consider: Even if the fund manages to survive the draw on capital and maintain its value, taking capital distributions reduces the investment’s cost base, sometimes to zero if clients are taking the RoC distributions for long enough. This essentially turns the fund’s entire value into a full capital gain, even if the fund’s value has not gone up or down. In fact, if the fund has decreased in value, taking contributions in this way reduces the losses clients have available to carry back or forward.
Like any withdrawal program too, taking distributions at the wrong time can erode the client’s capital far more quickly than they might like, especially if they find themselves drawing on their assets when markets are lower.
Aside from one very specific example where clients have large accrued gains invested in A-series units of a fund, Mr. Hallett says he has very little use for T-series units. "It’s a tax deferral strategy that will only last a few years and that is only available to investors with large accrued gains," he explains.
When talking about the psychological appeal of a product that returns money each month, he says it is possible that some advisors are simply giving in to client interest and demands when making use of T-series units. "It’s largely psychological. I can’t think of any tangible benefit of having a T-series of this fund versus an A-series share of the same fund," he says. "Assuming there are no transaction costs for selling A-series shares, and the vast majority of the time there isn’t, economically it’s the same. You’re in the same position. They’re two pieces of the exact same pie."