Bond ladder or ETF during RRIF withdrawal?

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like_to_retire
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Bond ladder or ETF during RRIF withdrawal?

Post by like_to_retire » 26 Dec 2010 09:41

I wanted to get some opinions regarding the use of ETF's or nominal bonds/GIC's during RRIF withdrawal years.

I've always been a proponent of using ETF's during accumulation years, then switching to ladders during retirement.

With regard to an open account as long as you don't see the need to exceed the cash thrown off by a bond ETF, then I agree it doesn't really matter if you use a nominal bond/GIC ladder compared to a bond ETF. But, if there's a need to consume capital when the cash thrown off by the ETF isn't sufficient for your needs, then I feel it would be better to use a ladder. If rates are rising, the ladder avoids selling units with a depressed NAV (as with an ETF), as capital can be withdrawn from the bonds maturing at 100 cents on the dollar. I just generally prefer the ladder as I can control the duration and any capital gain liabilities, along with ensuring I keep the average weighted coupon rate near the average weighted YTM (minimum of premium bonds). I also get a defined rate of return and a know principle at maturity, and basically dislike paying for something that's so easy to do myself.

In an RRIF though, I've always held an unwavering opinion that it's never a good idea to use bond ETF's. The government requirement to make a fairly large draw on a RRIF each year is onerous. Any raise in rates would cause the NAV of the ETF to drop, requiring the sale of more units to make up the shortfall. With a ladder it's quite simple to take the required RRIF withdrawal from a maturing bond at 100 cents on the dollar each year. This philosophy has always seemed like common sense. In a recent thread on this very subject my long time opinion of keeping a ladder in a RRIF was spelled out by a respected FWF poster.

In this post Shakespeare says:

Since an ETF or fund is easier to manage during accumulation and gives a diversification advantage, it suggests that a reasonable strategy is to accumulate in an ETF or fund (or blend, so as to duration match), then at or before age 71 selling the ETF or ETFs (or fund/funds) and converting in one fell swoop to a ladder of similar duration.

I have always agreed with this philosophy and use the same approach, except for the fact that I used bond ETF/Funds up until I retired and then turned them into ladders in both my RSP and open account.

Nothing I've read has ever changed my mind on this until a recent short post by James Hymas. In this post jiHymas says: (my bold)

You don't need to sell (or mature) your holdings to withdraw from a RRIF - you can make the withdrawal in kind, which will not affect your portfolio at all, only it's tax status.

Depressed NAVs are wonderful! You can withdraw more of your holdings while paying the same tax.


That statement has stuck in my head since he wrote it, and I'm having trouble coming up with anything that refutes it. It's directly opposite what I have always preached.

I never really thought about it this way, but if I assume an ETF with a depressed NAV will eventually recover when rates stop rising (and depending on its duration), then the process of transferring an increased number of units out of the RRIF because of their lower price, results in deregistering units at a better tax rate. In fact, you'd almost wish rates would rise so that your ETF units value would drop, so it would require a larger number of units to transfer out in kind to satisfy the previous year end market value. Those units would eventually appreciate in the open account when interest rates stabilized. The result would be a deregistering of the RRIF units at a better tax rate. This all presumes you only require the cash flow from those units when moved to the open account.

Alternatively, if rates dropped and the NAV of the ETF units increased above your cost base, then fine, sell them for cash inside the RRIF to realize the amount needed for withdrawal. You've made a capital gain that you must pay tax on.

I'm sure my mind is clouded with Christmas turkey and some clever FWF member will put me back on a clear path.

What is the argument against this strategy in a RRIF?

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by Shakespeare » 26 Dec 2010 09:49

James made a more telling point later: when you reinvest the maturing GIC or bond in a ladder you expose yourself to greater interest rate sensitivity than if you sell (or withdraw) the ETF, since the reinvestment is entirely at the long end of the ladder (and hence the greatest duration).

Also, withdrawals in-kind are only useful when you're not spending the cash.

Nonetheless, you may be able to get a better rate on a GIC ladder than a short-duration ETF.
“A wise man should be prepared to abandon his baggage at any time.” -- R.A. Heinlein, The Door Into Summer.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by IdOp » 26 Dec 2010 15:40

like_to_retire wrote:I never really thought about it this way, but if I assume an ETF with a depressed NAV will eventually recover when rates stop rising (and depending on its duration), then the process of transferring an increased number of units out of the RRIF because of their lower price, results in deregistering units at a better tax rate. In fact, you'd almost wish rates would rise so that your ETF units value would drop, so it would require a larger number of units to transfer out in kind to satisfy the previous year end market value. Those units would eventually appreciate in the open account when interest rates stabilized. The result would be a deregistering of the RRIF units at a better tax rate. This all presumes you only require the cash flow from those units when moved to the open account.
That sounds correct, but wouldn't it also apply to a bond? IOW, if interest rates had risen such that a bond had a depressed value, you could transfer it out of the RRIF in kind. This would apply more at the long end of the ladder than short. You'd have a capital gain or loss at maturity.
Alternatively, if rates dropped and the NAV of the ETF units increased above your cost base, then fine, sell them for cash inside the RRIF to realize the amount needed for withdrawal. You've made a capital gain that you must pay tax on.
You'd have a gain inside the RRIF, but taking the money out, it would be taxed as regular income.

[Edited first paragraph]

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by like_to_retire » 26 Dec 2010 16:21

IdOp wrote:That sounds correct, but wouldn't it also apply to a bond? IOW, if interest rates had risen such that a bond had a depressed value, you could transfer it out of the RRIF in kind. This would apply more at the long end of the ladder than short. You'd have a capital gain or loss at maturity.
Yeah but, to remove an entire bond rung from a ladder, it would upset the entire ladder. Not really a good idea. The minimum RRIF required withdrawal would be quite a bit smaller than a full rung of a ladder. Normally, with a ladder you would set aside the RRIF withdrawal at maturity each year and then rebuy a new bond. The cash removed from the RRIF would be the exact minimum required and wouldn't attract any lump sum withholding tax.
The ETF seems like a better idea where you sell the required number of units to meet the minimum requirements. Hopefully, the NAV is depressed and you can get as many units as possible out.
You'd have a gain inside the RRIF, but taking the money out, it would be taxed as regular income.
Yes certainly. My point is that if the depressed NAV didn't work for you and in fact the NAV had increased, then you'd have a gain in your RRIF. That's not a bad situation. You've made some money, so take out the required minimum amount in cash by selling the units inside the RRIF.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by like_to_retire » 26 Dec 2010 16:24

Shakespeare wrote:Nonetheless, you may be able to get a better rate on a GIC ladder than a short-duration ETF.
Yeah, that's true. I guess you'd have to see if a similar duration ETF yielded about the same as your existing ladder. If less, you could attempt to calculate whether the ETF route would save more on taxes in the long run.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by IdOp » 26 Dec 2010 18:03

like_to_retire wrote:Yeah but, to remove an entire bond rung from a ladder, it would upset the entire ladder. Not really a good idea. The minimum RRIF required withdrawal would be quite a bit smaller than a full rung of a ladder. Normally, with a ladder you would set aside the RRIF withdrawal at maturity each year and then rebuy a new bond. The cash removed from the RRIF would be the exact minimum required and wouldn't attract any lump sum withholding tax.
Sorry if it read that way, but I wasn't suggesting to withdraw more than the RRIF minimum requirement. Since bonds are transacted in amounts of $1k face (over $5k), I'm pretty sure you could transfer out about as much as you want up to the minimum. Any extra, say ~ $500 on average, would come from cash.

If transferring a bond out eventually led to a shortfall of cash to take out of the RRIF, then I think one would have to embrace further the concept of transferring assets out, so it may not be that unworkable.

At the moment I can think of 2 or 3 potential drawbacks to this approach, though.
(There are most probably more.)

1) Deciding which assets to transfer out, if necessary, in subsequent years requires more thinking. As a price to be paid for the tax advantage, this might not be that bad.

2) Taking cash out of a RRIF for the required payment is free. If there was a fee to transfer an asset out, that would be worse.

3) If requirements for cash outside the RRIF (living expenses, etc.) meant you had to sell a bond (or part), that would not be good.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by like_to_retire » 26 Dec 2010 19:29

IdOp wrote:Since bonds are transacted in amounts of $1k face (over $5k), I'm pretty sure you could transfer out about as much as you want up to the minimum.
Yeah, I don't know how easy it would be to transfer out a portion of a bond from a RRIF, and it sure wouldn't work if any rungs of the ladder was a GIC.

I guess I'm just intrigued by the notion that a loss in the value of a bond ETF in a RRIF could be considered a good thing, where I always flagged it as a bad thing. It seems to me a pretty good idea to lower the tax rate on de-registerering a RRIF. Maybe I'm wrong and there's something I haven't thought through correctly.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by IdOp » 26 Dec 2010 22:32

like_to_retire wrote:... it sure wouldn't work if any rungs of the ladder was a GIC.
Agreed.
I guess I'm just intrigued by the notion that a loss in the value of a bond ETF in a RRIF could be considered a good thing, where I always flagged it as a bad thing. It seems to me a pretty good idea to lower the tax rate on de-registerering a RRIF.
I also find it interesting. I guess an asset going down is a bad thing for the owner, but if you can get a tax win out of it that's good (a bit like tax-loss selling). Of course this assumes the asset will bounce back. For a high quality bond, if you take it out below par, you know what cap gain to expect. For a bond ETF, there should be a good chance it recovers eventually if it's low enough.

OTOH if the asset continues on down to zero, this would seem a bad move. So you'd have to pick your spots, as the discussion above does.

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Re: Bond ladder or ETF during RRIF withdrawal?

Post by jiHymas » 27 Dec 2010 12:23

Since my name has been mentioned, I should mention that I consider the entire ETF vs. Ladder controversy to be a red herring. As I showed in my article Bond ETFs demystified, the returns are basically identical (after accounting for MER and ignoring the potential for default), although the cash-flows differ somewhat under different conditions. How could it be otherwise?

The emphasis on recouping par value at maturity is something I find very mysterious. If you have a one-year note yielding 2% to maturity, does it really matter if it has a 3% coupon and is priced at about 101.00 or if it has a 1% coupon and priced at 99.00-ish? Especially in a registered plan where capital gains lose their identity? Either way, you have a one-year instrument yielding 2% for the year; if it fits with your portfolio goals, great; if it doesn't, swap it for something that does.

And I will again emphasize that the critical advantage of an ETF over a corporate bond ladder is diversification. If you have more than 5% of your fixed income portfolio in a single name, you're taking on a big chunk of credit risk and should be demanding a big yield premium to compensate - a yield premium that is simply not available in the straight bond market. For this diversification, you pay a relatively modest fee, in terms of MER. It's the cheapest insurance you're ever going to be offered.

I'll go further: if you're making a decision between a corporate bond ETF and a corporate bond ladder and either one has less than twenty independent names, then any further comparison is a waste of time.

A GIC ladder - if kept within CDIC limits - virtually eliminates credit risk (I say "virtually" because governments have been known, on occasion, to break their promises), but at the expense of liquidity; liquidity is the other advantage ETFs have over retail-sized fixed-income portfolios. Even if the GIC has an early redemption feature, or is transferable, the price you get if forced to sell will be derisory. And to those who say they don't need liquidity, I have one question: why are you invested in short-term instruments?

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