Terry Halton didn't have the typical midlife crisis often associated with buying a Corvette. It was more like an early retirement reward.
The 62-year-old retired helicopter pilot treated himself to his dream car. "I've finally gone ahead and done it," says Mr. Halton, a widower who lives in the Greater Toronto Area.
The once-in-a-lifetime splurge might make most early retirees a little nervous – but not Mr. Halton. "I guess that's part of the comfort of what happens when things are invested safely and securely," he says.
Mr. Halton has no work pension, nor does he have deep pockets.
Yet he is confident enough in his finances to make the big-ticket purchase because his retirement income strategy is tied to a steady monthly payout from an income-oriented mutual fund.
While guaranteed income certificates (GICs), government bonds and other fixed-income investments currently pay about 2 per cent a year, income-oriented mutual funds can offer investors double that yield.
As a result, income funds are attracting the attention of a growing number of retirees seeking steady income from an RRSP or RRIF.
Generally composed of bonds, dividend stocks, real estate investment trusts (REITs) and preferred shares, income funds straddle a variety of fund classes simply because there are so many ways to generate income, says Mark Raes, head of product management with BMO Global Asset Management.
"To me an income fund is any mutual fund or an ETF [exchange-traded fund] that's producing a stream of income, and that can mean many different things."
It can be classified as a bond fund, for example, because it's composed mostly of bonds, or it can fall into the dividend fund category because it holds mainly dividend stocks.
But most income funds are actually balanced funds – investing in a mix of stocks and bonds. And they are indeed the investment of choice for an aging population if the recent popularity of balanced funds is any indication.
According to Investment Funds Industry of Canada statistics from the end 2014, balanced funds make up the lion's share of the market with about $572-billion under management compared with the next largest class, equity funds, with about $374-billion.
Assessing just how much of the market actually consists of income funds is difficult because they come in so many varieties, but Mr. Raes says they are very popular. Their cost widely varies, with MERs (management expense ratios) generally between 1 and 2 per cent per year for most income mutual funds, and much less for ETFs.
"We have a few flagship income funds that are at the very top if not the most popular mutual funds on the shelf."
Yet what sets a truly income-oriented fund apart from other balanced funds is it's specifically designed to generate monthly distributions without having to sell fund units, so the capital largely remains intact.
Choosing the right fund, however, requires diligent research to strike the right balance between income, capital preservation and growth, Daryl Diamond, a certified financial planner in Winnipeg, says.
"It can be a core for delivery of income in retirement, but consumers need to be selective," says Mr. Diamond, author of Your Retirement Income Blueprint, now in its second edition.
More pointedly, investors must understand how a fund produces its yield to pay monthly distributions, because they want to ensure it is sustainable over the long term. That's about 4 per cent a year in today's marketplace – even though some funds may yield more than 5 per cent annually, certified financial planner Bob Challis says.
"The sales shtick might be that you're getting a 6-per-cent annual return," says Mr. Challis, an adviser with Nakamun Financial Solutions in Winnipeg.
But this is often misleading because investors can mistakenly assume the return is guaranteed, so when the fund does not live up to the hype – generally in a bear market – the value of their investment falls because the payout they receive as distributions can largely consist of a return of capital. As a result, they are generally shocked and ultimately disappointed to find out they are being paid back their own money as income rather than what they thought would be a consistent return on investment.
If adverse conditions persist, a fund may even need to reduce its distribution, which could cause some retirees to draw even more capital to maintain the income they require.
Moreover, income funds are not suitable for all retirees. An investor generally requires a substantial chunk of capital to make the strategy effective.
Mr. Diamond says a retiree needs at least $100,000 to invest in one good fund for a monthly income of about $300 to $400 without significantly eroding the capital. "If the amount was about $400,000, I might recommend one or two, but I wouldn't invest in five different funds."
Other industry experts, however, argue that investors with assets exceeding $250,000 are better served by a professional money manager who can build a monthly income from stocks, bonds and ETFs, with management a cost of 1.5 per cent or less per year.
"I don't think anything beats an actual portfolio manager who builds a portfolio for your specific needs," says Rob Tetrault, a Winnipeg-based portfolio manager with National Bank Financial.
Yet even Mr. Tetrault says income funds can play a role for investors seeking a conservative strategy that generates consistent cash flow with potential for growth in the long term.
The most successful funds in this regard are well-diversified across several sectors with distributions generated mostly from interest and dividends instead of capital gains and returns of capital. While distributions might consist of substantial returns of capital in bear markets, they tend to increase in value while maintaining their payouts in good years, Mr. Diamond says.
"Even though the income is not guaranteed, these are strategies – with appropriate vetting – that come through just fine in adverse conditions."
It has been the right fit so far for Mr. Halton even after going through this past fall's market correction.
"This is my retirement because I have no pension income other than CPP, so absolutely it triggers anxiety to see your portfolio going down, but at the same time, I realize markets are cyclical and do recover."