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Teed off with ‘T-series’ funds

by | May 28, 2014 | SELF-PUBLISHED

There are better ways to generate retirement income

“T series” mutual funds, so named because they are supposedly “tax efficient,” have become a popular type of mutual fund for investors seeking a steady, high annual cash payout. The payout rate is given in the name of the fund. For example, a “T6 series” fund pays out at a 6% annual distribution rate. Now, most funds do not produce enough income to pay out 6% distribution. So how do they get such a high payout rate? Simple: They give you your own money back. Is it worth it?

They give you your own money back

The T-series fund accomplishes the distribution rate, whether 6%, 7%, or 8%, not by selling units as you would in a Systematic Withdrawal Plan (SWP), but by giving you your own money back as a large percentage of each monthly payment. That portion, called “return of capital,” is not taxable, for the very simple reason that it’s your own invested capital, presumably on which you’ve already paid tax.

Any interest, dividends, or capital gain received as part of the distribution would still be taxable, but it’s typically only a fraction of the total monthly distribution you receive. The tax-efficiency part of it relates to that portion of the investment that continues to grow within the fund on a tax-deferred basis.

Tax deferral

Each return-of-capital payment reduces the adjusted cost base (ACB) of your investment. Your ACB could conceivably fall to zero once all your invested capital has been returned to you. After that, any further return of capital distributions will then be treated as capital gains (because you are now getting back more than you originally invested), half of which you must include as taxable income. And when you eventually sell your fund, a zero ACB means you could have a bigger taxable capital gain or a smaller capital loss, depending on the performance of the fund.

In addition, T-series funds under a “corporate class” umbrella let you switch between funds under the same umbrella without triggering a capital gain.

Cost versus performance

Remember that T-series funds are in fact mutual fund investments – that’s easy to forget when you get wrapped up in distribution rates, return of capital, and adjusted cost base calculations. That means there’s an element of risk involved. Mutual funds, except for segregated funds, are not guaranteed. Performance of T-series funds will vary, as they do with any other mutual fund.

And, of course, there’s a cost involved. Depending on the fund company, T-series funds command a management expense ratio of anywhere from 1.8% to 2.8% or higher. This begs the question of why you’d pay someone that much to give you your own money back. The performance of the fund had better be enough to match that hurdle rate plus provide adequate income and growth to make your investment worthwhile.

What if it’s a crummy fund?

If a fund’s income from investments (interest, dividends, capital gains) is less than what it pays out in cash, it has to come up with the money by bringing in new investors, selling existing investments, borrowing, or increasing cash allocation. Ultimately, a poorly-performing T-series fund may have to cut distributions, which will certainly squeeze those investors who have been using the distributions to fund living expenses.

So if you’re considering a T-series fund, pay close attention to both the payout rate, the MER, and the fund performance to ensure that the distribution rate will be sustainable and that you’re not simply recycling your own money with a hefty cut for the “recycler.”

Better options for retirement income

T-series funds are just one option for creating a retirement income stream – and not necessarily the best one. Other better choices might include a mixture of annuity strategies, systematic withdrawal plans from regular mutual funds, segregated funds, and RRSP/RRIF maturity strategies. A Certified Financial Planner can help cut through the confusion, and devise the mix of retirement income vehicles that best suits your needs.

© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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