In my last post, I introduced the new Vanguard Retirement Income ETF Portfolio (VRIF), an asset allocation ETF designed for people drawing down their portfolio to meet regular expenses. VRIF holds an equal mix of stocks and bonds and will pay regular distributions with a target of 4% annually.
VRIF isn’t fundamentally new: it’s an example of a monthly income fund, a product that’s been extremely popular in Canada for more than two decades. Whereas traditional mutual funds and ETFs often make quarterly distributions that vary unpredictably, monthly income funds have consistent cash payouts. For example, the fund might set its payout at $0.10 per unit, so if you own 5,000 units you’ll collect $500 every month, regardless of the ups and downs of the market. This has obvious appeal for retirees and others who rely on predictable cash flow to pay their bills.
Monthly income funds can offer convenience and simplicity, but they might be the most widely misunderstood products in the investment industry. I think there are two reasons for this. First, the funds themselves are complicated, as the monthly distributions come from different sources, and this isn’t obvious to most unitholders. (Though I hope it will be by the end of this article.)
The second reason monthly income funds are problematic comes down to a behavioural bias. Many investors love the idea of yield: any time a fund pays a juicy distribution it attracts attention, and we’ve already seen this in the reaction to VRIF’s targeted distribution of 4%.
Some have welcomed that 4% payout as a huge improvement over Vanguard’s other asset allocation ETFs, which typically have yields closer to 2%. At the other end of the spectrum, some have asked why anyone would settle for a measly 4% when there are competitors that yield 5%, 6%, or even much more. Both arguments are misguided.
In order to make an informed decision about whether VRIF (or any other monthly income fund) is an appropriate choice for your retirement portfolio, it’s crucial to understand how it generates that 4% yield. Only then can you compare it with other options.
The four pillars of cash flow
To set the stage here, let’s be clear that a monthly income fund starts out like every other balanced portfolio: it’s just a mix of plain old bonds and stocks. Indeed, seven of VRIF’s eight underlying holdings are the same funds used to build VBAL and VGRO, Vanguard’s two most popular asset allocation ETFs. If all of these portfolios use similar building blocks, how can VRIF deliver almost twice the yield?
To answer that fundamental question, we need to understand that a fund’s cash distributions can come from four different sources:
- interest from bonds
- dividends from stocks
- capital gains from selling those bonds and stocks
- return of capital
The first two are obvious. Bonds make regular interest payments, and many stocks pay dividends, and this cash is paid out to the fund’s unitholders. In many traditional balanced funds, virtually all of the cash distributions come only from these two sources. That’s the case with VBAL and VGRO, and it explains why the yield on these ETFs is only about 2%: that’s all the underlying bonds and stocks pay in interest and dividends.
As we’ve noted, VRIF has similar holdings to VBAL and VGRO, so its cash flow from interest and dividends must also be similar. Indeed, Vanguard expects these two sources to make up only 60% of VRIF’s distributions, which works out to 2.4% in interest and dividends (60% x 4% = 2.4%). The remaining 1.6% has to come from somewhere else.
That brings us to our third source of cash flow: capital gains. In a traditional balanced fund, when stocks or bonds are sold at a profit, the manager usually reinvests the proceeds. But monthly income funds routinely pay out some or all of the proceeds to the unitholders in cash as part of the monthly distribution.
Now it should be clear why VRIF’s yield is expected to be so much higher than that of VBAL and VGRO. Since VRIF is specifically designed for investors who want cash flow, the fund will pay at least some of its capital gains in cash, boosting the distribution yield accordingly. Investors in VBAL and VGRO (presumably) have less of a preference for cash flow, so the managers will reinvest the proceeds of any capital gains realized within the fund.
There’s another important point to understand here. Balanced funds typically only realize gains when they have no choice: for example, if they need to rebalance the portfolio after a big market rally. By contrast, monthly income funds such as VRIF will be actively on the lookout for capital gains to harvest, because they need these to generate cash flow. VRIF should be expected to realize capital gains every year, or at least to try.
But, wait, you say. What if there are no capital gains during the year? Surely a balanced portfolio is going to experience negative returns from time to time, and there may be no opportunity to sell holdings that have appreciated in value during the year. That’s true, but this will happen less often than you might think. For example, one of the holdings might have appreciated by 15% last year, so even if it falls 8% this year it might still have an unrealized gain that can be trimmed. And in a globally balanced fund like VRIF, it’s quite possible that one or two of the individual holdings could go up in a year when the fund’s overall return is negative. It’s rare for all asset classes to decline at the same time.
Remember that VRIF only needs to realize modest gains (about 1.6% annually) to meet its distribution target, and that should be possible in most years. In fact, based on its backtesting, Vanguard estimates they’ll be unable to do so only about once every 10 years or so.
Income that isn’t really income
And what happens in a year where there aren’t sufficient gains in the fund? This brings us to the fourth potential source of cash flow in a monthly income fund. If VRIF is not able to realize enough capital gains to top up its distribution to 4%, then it will make up the shortfall by simply paying unitholders with some of their original investment. This kind of cash flow is called return of capital (ROC).
Savvy investors understand that return of capital might feel like income, but it’s not like interest, dividends or capital gains. Think of it like this: if you deposit $1,200 in a chequing account and then withdraw $100 a month for year, is that account generating income? Of course not: it’s just an illusion. If you spend that $100 every month you’ll be broke at the end of the year, and if you reinvest it you’d just be back where you started. That’s why ROC is not taxable: because it’s not real income. It’s also why every $1 paid out in ROC causes the fund’s value to fall by $1, resulting in an investment return of zero.
Return of capital is not an inherently bad thing, but it can cause at least two potential problems.
First, it can mislead investors, because it’s largely invisible. When those cash distributions hit your account every month, you won’t immediately know whether they came from interest, dividends, capital gains or ROC. If you hold the fund in a taxable account, you won’t know this breakdown until you receive your T3 slip at year-end. And if you hold the fund in a registered account, you won’t even get a T-slip, which means you’ll need to visit the fund’s website to look up the details. Most people won’t do that. So if a fund’s distribution includes large amounts of ROC, investors may naively believe their portfolio is generating real income and growth, when in fact the fund is artificially inflating its yield by giving them back their own money.
The second problem follows from the first. Remember that every dollar paid out in return of capital causes the fund’s unit price to fall by the same amount. If your monthly income fund routinely pays out a lot of ROC, the value of your portfolio will fall steadily and your retirement savings will dwindle over time. That might be fine if the decline is gradual and your financial plan has factored this in. But if you’re spending all of those monthly distributions and assuming they’re sustainable throughout your retirement, you might be in for an unpleasant surprise.
The good news for investors considering VRIF is that this fund is very well designed, and its 4% distribution is likely to be sustainable over long periods. The same can’t be said for some of its competitors. I’ll explain more in my next post.
Excellent article as usual. It confirms the simple truth that many investors miss: there are no free lunches. There is always a tradeoff.
Very interesting. I think this could be a good product as long. as you understand the risks and where the income is really coming from. I like the convenience of these types of products. The complexity of post-retirement income from various investments (RRSP, TFSA, savings, non-registered accounts) is daunting and not something most people think about in the investing stage.
I actually like the idea of cashing in a good portion of capital gains. I have some managed funds where stocks have had a great capital gain then I find these stocks are still in the fund after it has lost a significant portion of those gains. In addition, I paid dearly and ever more so to get to the good capital gains situation and then continued to pay dearly as that capital gains was eroded. There are many funds who objective is the protection of capital but I wonder are there any ETF`s whose primary goal is to maximize realized gains from capital gains?
On sustainability of the 4% distribution, I’m not sure there is a lot of room for errors. As you need the asset mix of VRIF to give you at least 4% (including capital gains, dividends, coupons).
And so, I was trying to figure out how much you need from equities to make it work. I find it’s easier to estimate expected return for bonds, as the yield to maturity is a good proxy for long term returns (e.g. 10 years). At the moment, it’s about 1% for most bonds (hedged back to CAD). And bonds are half of this product. So, if my calculations are correct, you need equities to deliver 7% return (assuming bonds give you 1%) to get to the 4% long term total return.
And based on today’s valuation, 7% is at the high end of the ranges I’ve seen. Now, it’s fairly subjective but I think breaking it down this way is a useful insight.
I’d love to hear different perspectives.
@Alex7: You’re definitely on the right track here. The expected return on bonds is probably higher than 1% because most of the portfolio is corporate bonds: VCB has a yield to maturity of 1.7%. As for the expected return on stocks, it’s true that these forecasts are highly unreliable, but Vanguard has said that it will consider valuations and long-term expected returns for each of the asset classes (Canadian, US, international, emerging) when tweaking the allocations. I’ll explain in more detail in my next post.
The capital of ROC is multi-sourced: new inflow of money into the fund + capital gains accumulation. If only “1.6% annually” is req’d to payout 4% then it’s reasonable to suggest that in bear markets ROC isn’t a negative thing. I’m thinking VRIF a better product than an annuity?
You have written an interesting article that is both informative and easy to comprehend. Well done.
Monthly income funds are not something I have explored and probably won’t use them as I simplify our portfolios, but I understand them better having read your two recent articles.
On the face of it, vrif seems to be a great strategy during drawdown phase. But it’s a recipe for disaster during accumulation phase. My question is, at what point would a CCP transfer over from say veqt to vrif. It would be easy on maintenance to switch in a single shot but that can lead to a huge tax bill in a cash account. Now one can be tax efficient by making gradual shift over years but then how is vrif making my retired life easy?! I’d wait for target-date vrif!
I’ve at most 3 1/2 years to retirement. I have 6 figures of essentially cash I’d like to deploy (non-registered account).
Would it make sense for me to *now* buy into VRIF, knowing that I probably won’t be retiring for a few years? My other option would be to put it into something like VBAL, but then I’d have the issue of a tax hit if I wanted to switch to VRIF at retirement time. I would like to do *something* productive with this money, so any guidance/advice appreciated.
A 2nd question is whether VRIF makes sense for a RRSP? My take is that the requirement for mandatory RRIF withdrawals (at age 71) should work nicely with this fund. Am I mistaken? FWIW, my RRSP is now a couch potato portfolio of individual ETFs (XIC, XUS, etc).
TIA
And thanks for the 2 informative articles on VRIF. Always a pleasure to read your articles (plus the many good comments).
Thank you for the excellent write-ups. More questions come to mind the longer I think about this. The distribution amount depends on the number of shares you own, not the dollar value of your position, so the 4% yield was true on the day the ETF listed, and would be true for you if you bought all your shares that day, but will effectively vary for everyone else- am I getting that right or am I missing something? Regarding the fact that the fund will sometimes carry surplus gains forward into the next year to be used for distributions when market returns are lower- does that provide any opening for opportunists to swoop in and buy shares when the fund is in that state of holding gains from the past? Or does that get arbitraged away daily in the movements of the share price? As a final question, I’m still unsure of the basic question of whether this is a passive fund or an active fund- if am someone who came to be convinced, by the CCP blog, etc., that passive investing makes the most sense, and no one knows about future asset returns any better than the information baked into current prices, could I, without contradiction, invest in this fund?
@Jim: Thanks for the comment. Of course, I cannot know whether VRIF or any other fund is right for you. In general, if you are planning to use VRIF in a taxable account in retirement but you’re still a few years away from needing the cash flow, you could simply reinvest the distributions in the meantime. I would not normally recommend any monthly income fund for people planning to reinvest, but this might be one circumstance where it would be a reasonable (temporary) choice.
I’ll be doing a future blog about the practicality of using VRIF in a RRIF. Short answer: it can’t be a hands-off solution, because the mandatory withdrawal rate on RRIFs is more than 4%, so you will need to top up those distributions somehow.
@Moti: More to come, I promise! In the meantime:
– The current distribution is based on 4% of the $25 share price on the day of launch. So you’re correct, if you buy the fund today and the price is higher or lower than $25, then your yield will be a little lower or higher in percentage terms. The distribution will be adjusted annually to stay very close to that 4% target.
– All ETFs carry unrealized gains forward to future years: there’s no opportunity to exploit this.
– I’ll be explaining VRIF’s changing asset mix in a future post. Active v. passive is a not a black-and-white distinction, so it will be up to you to determine where it falls on the spectrum!
hello, really cool article, simple and clear, even I understood everything. And although I am still far from retirement, my father has been interested in this issue for a long time, so I decided to find out everything for him. And now everything seems to be clear, but I read about 2 more types of VRIF (active and passive) on another site and I would like to ask you what you know about it, what are the advantages and disadvantages of each of them?
Good overview, thanks. I’d like to hear more about your thoughts on using this type of monthly income in a RRIF, realizing the 4% yield will not cover the full distribution load for an investor past their mid 70s.
@Gordon: It’s true: if you use this product in a RRIF it will not be hands-off, since the mandatory withdrawal rates are higher than 4% if you’re older than your late 60s. I’ll be looking at this issue more closely in a future post.
Thanks for the series on VRIF and I am looking forward to your next posts on it. Probably not coincidentally, the 4% reminds me of the 4% “safe withdrawal rate” rule where you can withdraw 4% of your portfolio in the first year of retirement and then adjust that amount for inflation in the following years, and expect your portfolio to outlive you (I think with around a 75% equity/25% bond allocation). But this 4% from VRIF seems to be a bit more aggressive, since it is 4% all the time from a more conservative asset allocation. Do you have any idea if Vanguard intends for the $25 unit price to also grow with inflation (keeping the yield constant in real terms), or is the goal to keep it around $25 (slowly eroded by inflation)?
@Tyler: As you’ve recognized, the 4% distribution from VRIF has no direct connection to the “4% rule.” The 4% figure for VRIF will be recalculated every year based on the current value of the fund, so it can go down as well as up. With the 4% rule, the annual withdrawal would never go down unless there was deflation.
Vanguard has said it is targeting a long-term return of 5% for VRIF, a percentage point higher than the distribution. But of course this will vary dramatically from year to year.
https://canadiancouchpotato.com/2020/10/05/is-vrifs-distribution-sustainable/
Does the 4% distribution vary? I see on Vanguards overview sheet the income distribution per unit is $0.083333. At the price today of $24.64, does that make it a 3.38% monthly payout?
@Dan Milton: See the last section in this blog:
https://canadiancouchpotato.com/2020/10/05/is-vrifs-distribution-sustainable/
For the record, the current monthly distribution of $0.083333 is $1 per year, making the current yield 4.06% based on a price of $24.64.
Could you comment on the difference between the 5% yield of ZPR which is a dividend I think and VRIF’ s 4%? – which is safer?
@Tony: That’s hard to answer. Dividends on preferred shares are highly unlikely to get cut, but some preferreds are designed to have their payouts change according to prevailing rates. The bigger question here is risk. There is a big difference between a globally diversified portfolio of stocks and bonds (VRIF) and a fund that is entirely made of preferred shares from Canadian financial institutions (ZPR). You can probably guess which will be more volatile!