Income investing:
How to yield better cash flow

yield (verb): The income return on an investment. This refers to the interest or a dividend received from a security and is usually expressed annually as a percentage based on the investment's cost, its current market value or its face value. Yield Definition │Investopedia

Investing to generate income with less risk is a common quest nowadays. As more baby boomers become spenders rather than savers, the demand for cash flow is growing as fast as their hair is greying!

Yield income isn't just for retired people – it's a powerful wealth-building tool for working folks, too. Income investing, or the idea of selecting securities in part for the income stream they can potentially provide, is an effective strategy in anyone's total-return tool box.

So how do you receive income? Not long ago, we counted on the returns from the most secure financial instruments, like guaranteed investment certificates and Government of Canada bonds. But ultra-low interest rates are dampening the returns of many of these traditional income-producers. So, income-seeking investors are starting to look to the yields from a more diversified portfolio of securities.

Here are six practical ways to get more income diversification.

1. The role of income in total return

Total return includes both the change in the price of a security and any additional cash flow the holders of that security may receive over a specific period. Dividend and interest income streams contribute to the total return of investments. Common stock, preferred stock and bonds are all different in their income-generating properties.

2. The cost of cash

It's often wise to set aside some cash to take advantage of new investment opportunities. But holding too much for too long is no way to invest. Even at a 3% rate of inflation, cash can lose nearly half its purchasing power over a 20-year retirement span. To balance risks and generate returns that aren't eaten up by inflation, you need more diversified income strategies than ever before.

3. Seek income in many places

To beat inflation, look for new income opportunities in familiar places. Higher yields in corporate bonds, preferred shares and sovereign debt funds in emerging markets are good options. Many companies today pay dividends that deliver twice the yield of the benchmark 10-year government bonds, which is about 1.7% a year. These are solid companies with the potential to grow their dividends – chances for income growth and capital appreciation!

4. Rising interest rates require caution

Central bankers around the world have sown the seeds of inflation with monetary stimuli. Interest rates may be rising on the medium-term horizon, and when interest rates go up, bond prices go down – eroding spending power and creating capital losses, too! Income-producing assets react differently in changing interest rate environments. By diversifying an income portfolio into assets for which market values tend to rise along with interest rates – such as dividend-paying, high-quality common stocks; income equities like REITS and preferred stocks – you can shore up some downside protection.

5. Future value of good companies

Investors can hurt their total returns and sabotage their retirement income by having too little exposure to stocks, particularly in a high-inflation environment where growth is needed to maintain purchasing power. Wary investors have depressed the price of good growth companies by turning their backs on equities. Value managers believe the way to generate the best returns is to buy undervalued stocks. Ideally, you want to own shares in good businesses that will be able to pass higher costs on to their customers and grow bigger and more profitable in the future.

6. Rethink your planning horizon

Many people see price volatility as being the real risk, while we think the more serious danger is running out of money before you die. Retirement is not the end of your planning horizon. Today's retired 60-year-olds typically have real time horizons of 20 years or more. Equity allocation for retirees must be based not just on immediate cash flow needs, but on their long-term goals, too.

We don't believe the direction of interest rates or the volatility of markets should determine your retirement standard of living. With a managed approach, we aim to meet your needs for income, greater diversification and growth potential, for however long you need it.

Pre- vs. post-tax dollars
It's not what you earn, it's what you keep!

It’s one of those truisms that have been around since the birth of income tax in 1917! During our working years, we do our best to minimize or reduce our tax bill. But what happens in retirement when we begin to live off those hard-earned savings?

Usually with investment options, the first comparison is the pre-tax interest rate, yield, or rate of return. But this doesn’t account for any taxes you must pay. So it’s the after-tax return that you need to consider. It shows how much you get to keep or spend...depending on how you look at it.

Non-registered investments are not tax-sheltered like RRSPs or TFSAs. So taxes will be due on the interest, dividends or capital gains you earn on them. What you need to understand is that each type of investment income is taxed very differently.

First, interest income is taxed on the entire amount earned. Eligible dividends from public Canadian corporations qualify for an enhanced federal and Ontario dividend tax credit, which reduces the amount of tax you must pay. Finally, the amount of a capital gain that’s taxable is only 50% of the actual capital gain realized.

For example, let’s assume an investor lives in Ontario and is in the top federal tax bracket, with taxable income of over $132,406 in 2012. If each investment generates a 4% yield, here’s how they compare after tax.

After-tax income clearly shows the preferred tax treatment. All capital gains and eligible Canadian dividends – regardless of your tax bracket – are taxed at lower rates than other investment income, such as interest and foreign dividends.

Dividends from either preferred or common shares get a more favourable tax treatment than plain interest income does. Consider this: a 3.8% eligible dividend has the same after-tax return as 5% in interest income. To put the same amount in your pocket, the interest rate would have to be more than 1.3 times the dividend rate!

ASK & ANSWER
Beneficiary designations and wills

ASK
It seems counterintuitive that I should make my estate, not my daughter, the named designated beneficiary on my RRSPs. Can you remind me why?

ANSWER
You wrote a new will in January 2012, primarily to set up a testamentary trust for your daughter, Amy. A testamentary trust affords your beneficiary – Amy – the tax advantage of future income-splitting, i.e., paying a lower tax rate on investment income that’s earned on inherited capital.

Direct beneficiary designations on RRSPs are a way to by-pass the estate. To fund a testamentary trust, your assets must pass to your estate at the time of death, and NOT by-pass it. Otherwise, it would frustrate the intention of your will and its trust provisions.

Your current will revokes any previous beneficiary designation in your RRSPs. Instead, it provides that the net proceeds will be paid to Amy’s trust. Changing your beneficiary designation with your financial institution aligns those documents with the content of your will. It saves administrative confusion (or delays) with the financial institution later, too.

Have a financial question that you need an answer to? Just ask.

WDS READS
UNINTENDED CONSEQUENCES: Why Everything You've Been Told About the Economy is Wrong

Edward Conard, Penguin Portfolio, June 2012
Former Managing Director of Bain Capital, LLC

In the wake of the 2008 financial crisis, I studied reams of commentary in the popular press about its causes. Most thought that predatory U.S. mortgage lending practices and fraudulent syndication were to blame. Having read Unintended Consequences, I now appreciate that taken alone, those reasons are simplistic. Bottom line: mortgage defaults didn’t make banks insolvent; depositors’ panicked withdrawals did! The crisis revealed the enormous risk of damage associated with sudden and massive bank withdrawals and the impotence of having implicit government guarantees to hold those withdrawals in check. The author promises that his book will reward you with a sophisticated understanding of risk taking, innovation and investment in the contemporary U.S. economy. It delivers.

A testimonial about this book:

Edward Conard has written a provocative and important book about the economy that challenges conventional wisdom about the Financial Crisis, the trade deficit, government policy, and the path to prosperity. His insights into the kind of risk taking we need to spur innovation and job creation are particularly salient, given the inevitable flight from all risk coming out of the crisis. I hope policymakers and business leaders will pay close attention to Conard’s framework. —William A. Sahlman, Senior Associate Dean, Harvard Business School