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Generating income in a low-rate retirement

Building an income stream must begin first by discovering two facts that are entirely personal to the individual’s situation.

Barb McKay, 68, and her husband, Don, 69, are the poster seniors for the restless lifestyle that begins after six decades.

They're part-time farmers in Wellington County, Ont., where they mentor veterinarian students. She volunteers overseas several times a year and he's a municipal politician. They have ambitious philanthropic goals to gift part of their estate to the charities they're involved with. And despite the frantic pace to their lives, they consider themselves retired.

They are also supersavers and conservative with their finances. When they first began to look at retirement, their RRSPs were filled with GICs, cash and assorted balanced mutual funds first purchased in the 1980s, when interest rates had double digits.

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"Particularly with the mutual funds, I felt we were reasonably diversified, but when we took a closer look at the various mutual funds we had, what they were being invested in was pretty similar," Mr. McKay said.

When Mr. McKay finally packed up his consultancy work in 2007, the couple began working with Geoff Newton, an investment adviser with BMO Nesbitt Burns Inc. He said the McKays' investments were doing well but had the potential to do a whole lot better.

"Their investing career needed to evolve. It needed to employ advice," he said.

Mr. Newton produced a comprehensive retirement plan that included asset allocation, tax management, diversification and appropriate risk management, as well as an income stream derived from fixed-income securities.

An income stream is a retirement-planning technique that uses the interest generated by fixed-income securities such as GICs, bonds or bond funds to produce cash at regular intervals, which conveniently replaces a regular paycheque if a pension doesn't exist or needs supplementing.

Fixed-income securities are generally safer and less volatile than stocks, although a change in interest rates influences the value and yield. Guaranteed investment certificates are, of course, guaranteed, but a whole universe of different risk ratings exists between safer government-backed bonds, those issued by blue-chip corporations and junk bonds that are regarded as high-risk.

While many retirees look to an income stream to cover month-to-month expenses, the McKays both have pensions and Mr. McKay receives a salary as a councillor.

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"They are not in a day-to-day situation that they have to rely on the income that they get from their portfolios, but it is obviously a major complement to how they feel they need their cash flow to look like, to be able to do what they want," said Mr. Newton.

Currently, the McKays' income stream derives from a cornerstone of GICs and federal and provincial bonds. Short-term cash positions and bond funds are added to the mix.

Mr. Newton said that with longer-term GICs and fixed-income bonds coming due, and with rates so low, bond funds are an excellent complement to the core strategy.

"Bond funds do offer, in the current environment, a slightly better rate of return with some acceptance by the investor of taking on the risk of rates moving higher," he said.

Darren Farwell, senior wealth adviser with ScotiaMcLeod, said building an income stream must begin first by discovering two facts that are entirely personal to the individual's situation.

First, what is your risk tolerance for equities versus fixed income? That will determine what percentage of your investments will be generating cash flow.

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Second, how much money you will actually need to live on? The withdrawal rate naturally has to be a high enough amount of money for living expenses or to supplement your income but can't be so high that you would deplete your funds in the middle of your retirement.

Mr. Farwell said a 4-per-cent withdrawal was traditionally used – when interest rates were higher – as a proportion that would ensure retirement savings should last a lifetime. More recent studies have shown that the rate may be closer to 3 per cent to absolutely safeguard against outliving your funds, Mr. Farwell said.

He said one way of arranging the various investments is to keep the current year's source of income in a money-market fund, the next year or two in GICs and the rest in bonds or bond funds – again, depending on risk tolerance and need.

Mr. Newton said he doesn't believe a single rate hike will have any material impact on the fixed-income side of his clients' portfolio. Multiple rate hikes are a different story. He said he has been preparing his clients for a period of rising interest rates.

"In this environment, quite honestly, the opportunity for retirees is a strong one right now in fixed income because, in theory, if rates start to move higher, then that means retirement income should follow. So we may have already weathered this storm on the fixed-income side of the equation," he said.

"Rates moving higher for someone on fixed income is not a bad thing. It's a good thing."

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