The Art of Cashing Out

It’s a well-accepted fact that the first success factor of retirement is a good plan. But the second one is about selling. "Optimizing the order in which financial products are disbursed makes all the difference in determining whether or not you will run out of money," says Alexandre Bathurst, partner at Planex Financial Solutions.

Starting retirement with a portfolio that is too inflexible is a common mistake this planner has encountered. "Too often, I see retired people forced to adjust their lifestyle to the products in which they are invested because these are frozen for three to five years.”

Another common mistake is that these retirees burn too much money in the early years of retirement, despite a plan that provided otherwise. In early retirement, some of them rush to buy the first luxury car of their lives or pay for a big trip. "After that, they wonder why they're tight in their savings," notes Bathurst.

Separate Your ‘Selling’ Fund
Setting up a disbursement fund that respects the guidelines of the retirement plan is a key measure put forward by several planners. This is a "reserve" portfolio, which consists mainly of short-term income securities, such as money market funds or bonds with maturities of two or three years. This fund provides a stable income for a period of one to five years, depending on the risk tolerance of the retiree.

On the one hand, you build a portfolio that consists mainly of equities that provide growth to assets," explains Carl Thibeault, Senior Vice-President, Quebec, at IG Wealth Management. On the other hand, you build a more conservative portfolio of fixed income securities from which you derive regular income. For example, if the retirement plan calls for $2,000 per month from the asset portfolio, you set up a fund of $48,000 for two years or $72,000 for three years.

This more conservative portfolio does not need to be built up in a single streak. When the stock portfolio is doing well, you can extract capital gains from it and put it into this more secure portfolio; when stocks are suffering, you don't transfer anything. "Ideally, you should have enough money in reserve to avoid drawing on the stock portfolio when it is down and get you past a bear market," says Carl Thibeault.

A retiree shouldn’t hesitate to create a reserve fund, insists Alexandre Bathurst. "A stock market correction hurts a portfolio more than a 1% loss in return with a more conservative fund," he says.

Early Retirees Can Cash Out Directly
A younger retiree, who has a longer life expectancy horizon, would find advantage in cashing out in regular monthly installments out of his single portfolio, without building up a "reserve", says Daniel Laverdière, Senior Manager, Expertise Centre, at National Bank Private Management 1859. He conducted a retro-analysis from 1980 to 2018 that compared 430 periods of 36 months (period of protection assigned to a "reserve"). "Eighty percent of the time, he notes, the '36-month reserve' strategy proved to be a loser. That's normal because part of the portfolio was not invested, but simply protected from declines.” In other words, a retiree who has built up reserves increases his or her risk of depleting capital faster than one who has been disbursing in regular installments.

Pensioners who use the reserve strategy have an interest in allotting a significant portion of their portfolio to growth securities. All observers agree that low bond yields call into question the old rule of thumb of devoting to bonds a portion equivalent to one's age, e.g. 70% of bonds for a 70-year-old individual.

I don't really agree with rules of thumb," says Carl Thibeault. You have to take into account your lifestyle, your assets, your risk tolerance. I think situations have become more complex and individualized analysis is required.”

Cashing out the House
A few other elements find a place in the disbursement process: the sale of one’s home and purchasing a life annuity. Since a house is a major asset in a retiree's portfolio, what should be done with it? Carl Thibeault believes it is better to sell it sooner rather than later. "The ideal, he says, is to diversify your assets. With half of your fixed assets in a house, it's better to sell it to achieve greater diversification.”

But beware. “You have to make sure that the house is a real asset," warns Alexandre Bathurst. A retiree who sells his or her house will have no choice but to pay rent, which will probably eat up most of the investment made from the proceeds of the sale of the house.

One option that some will consider in their disbursement strategy is to take out a reverse mortgage on the value of their home. Some financial firms offer to finance up to 40% of the market value of the house. But not all retirees are ready to live with the stress of a debt whose amount can fluctuate with markets.

A Place for Annuities
Finally, there are life annuities, which can be an interesting option. For example, a retiree who succeeds in selling his house with a capital gain that is not entirely eaten up by future rent could consider buying a life annuity with a portion of his capital gain. Especially if the retiree does not benefit from a stable income from a private pension fund, such an annuity could provide the equivalent. This stability can give the retiree the security he needs to invest the rest of his assets in growth securities.

However, returns on annuities are rather low at the moment. Thibeault gives the example of a basic life annuity on $100,000 for a 70-year-old retiree, without an insurance rider, which supplies an annual income of approximately $6,300. Thibeault approves devoting a small portion of assets to an annuity, but only if this fixed and insured income can be used to cover the fixed portion of current expenses. "Everyone needs a fixed income that provides certainty, and the older you get, the more certainty you need," he says.

But beware of the tax implications of an annuity, the specialist adds. "It's not uncommon to see effective tax rates of 75% and more. An annuity could force some retirees to repay part of their old age security pension. "Here again, you need to proceed on a case-by-case basis.

Don’t Forget Inflation and Taxes
Inflation and taxes are two crucial factors that a disbursement strategy must take into account. Thibeault suggests something to alleviate the anxieties these two scarecrows can cause. One is to match retirement expenses to a portion of investments, taking into account that expenses such as rent and electricity are less subject to inflation than gas and food. A retiree could aim to match the latter two expenses with the indexed income from a private pension fund. On the other hand, expenses that are less subject to inflation would be matched against the income from the investment portfolio, which in turn moves independently of inflation.

The same match can be made between different categories of taxes that apply to different types of investments (RRSPs, TFSAs, regular portfolios, dividend-paying portfolios, etc.). A judicious allocation can minimize the tax burden and better protect the retiree's purchasing power for the years ahead.