As interest rates and dividend yields have plunged over the past 5 years, our firm has advised people to reduce withdrawals to no more than 3% per year in order to reduce the likelihood of eroding principle. Periodically we have lost clients or prospective clients to other firms and companies who are promising higher levels of income. I call them ‘dial-risk-for-income’ advisors: “what level of income would you like to take from your savings sir? 7-10%? No problem! We will simply allocate more of your capital to riskier markets, and you can take whatever income level you need. Happy to help, our pleasure.”
People desperate for more income than their capital can safely provide, have been drawn to “high income funds” touted by the broker/dealer/mutual fund crowd as yielding 7 to 10% a year. Several “hybrid” and “structured” products have actually been paying out this level of distributions. For those who don’t believe in fairies, the relevant question is simply how. To us the answer was obvious: funds and financial advisors have been sending out above-market distributions by returning chunks of the investor’s own capital and calling it income.
This weekend, the Globe’s John Heinzl ripped off the lid on the BMO Monthly High Income fund and others in the ‘high income class’ revealing the truth behind their fees, spin and empty promises. See: Beware of funds that pay out more than they make
“Back in October, 2011, I wrote about the BMO Monthly Income Fund. At the time, the fund was priced at $7.57, and the distribution was 6 cents a month, or 72 cents annually. The annual “yield” – and I’m putting that word in quotations for a reason – was therefore 0.72 divided by 7.57, or about 9.5 per cent.
Wow! Sounds pretty good, right? No wonder Canadians have more than $4-billion parked in the fund. But let’s look at what has happened since…
Turns out the fund wasn’t actually making anything close to 9.5 per cent. Over the previous three years it had posted a total return – from dividends, interest and capital gains – of just 3.1 per cent after fees. How did it make up the difference? By giving investors their own money back.
When a fund distributes more than it makes, the unit price – or net asset value (NAV) – declines. As recently as 2007, BMO Monthly Income Fund’s NAV was more than $10. As of March 26, 2013, it had tumbled to $7.19. So, while investors were collecting those hefty distributions, their capital in the fund was gradually being eroded.
What’s more, because of the falling NAV, the distribution rate has continued to climb. It is now more than 10 per cent. There is simply no way the fund – which has about 53 per cent of its assets in stocks and the rest in bonds and cash – can generate that sort of return consistently. Given the meagre returns of bonds, the fund’s equities would have to shoot the lights out year after year.”
So after eroding some 29% of capital value over the past 5 years, (falling from $10 a unit to $7.20 today) on March 11 BMO finally issued a notice to unit holders that it will now be slashing distribution levels by 60% to 4.2% a year. But even this dramatically reduced level is still higher than actual income can provide and will have to see stocks average solid capital gains from here in order to keep up with promised distributions.
This has been yet another rude awakening for those who are buying the hope and hype of above-market income levels. The bottom line is that there is no magic solution to today’s low income environment. Risk-sellers cannot put you in different stock or bond markets for above-average income. If you believe such promises, you are near certain to pay for the experience with large chunks of your own capital. Here’s Heinzl: “The old adage about things seeming too good to be true is especially relevant when choosing investment products.”
Thanks John. A little truth in today’s land of nonsense and pixie dust is appreciated.