In my last few posts, I introduced the newly launched Vanguard Retirement Income ETF Portfolio (VRIF), explained where its 4% distribution comes from, and considered whether that payout is sustainable. Now it’s time to explore how you might use VRIF in your own portfolio— and when you should avoid it.
Using VRIF in a RRIF
With “Retirement Income” right in its name, it’s natural to consider using Vanguard’s new ETF in a RRIF account. RRIFs, of course, require you to make regular withdrawals, and many retirees receive these monthly. Since many RRIF holders don’t like to sell their holdings to free up cash for those regular withdrawals, VRIF’s monthly distribution schedule might be just the ticket.
But if you already have a RRIF, you’ve probably spotted the wrinkle. VRIF’s annual distribution is fixed at 4%, and unless you’re younger than 65, the minimum withdrawal rate from a RRIF is higher than that. For example, say you’re 72 at the start of the year and your RRIF holds 12,000 units of VRIF with a value of $300,000. At your age, the minimum withdrawal for the year is 5.40% of that balance, which is $16,200, or $1,350 per month. However, the distribution from VRIF will be only $12,000 annually, or $1,000 a month, so you’ll need to find a way to make up that shortfall.
Of course, in theory you could simply sell a few units of VRIF to free up that extra $350 a month, but this is inefficient, inconvenient, and doesn’t help retirees overcome their reluctance to sell holdings to generate income. Really, it defeats the purpose of using a monthly income fund. If you were resigned to selling units frequently, why not just stick with whatever ETF portfolio you were using in your RRSP before you converted it to a RRIF?
I’d argue there’s a simpler way to manage monthly RRIF withdrawals. At the beginning of the year, as soon as you know how much your required withdrawal will be, you can sell some holdings to raise that entire amount. (If you’re using a traditional asset allocation ETF for the whole portfolio, this is just a single trade.) Then you can put the proceeds in an investment savings account and set up a systematic withdrawal plan to make the monthly payouts. This requires you to do a little maintenance only once a year, which is about as easy as it gets. The truth is, there’s no such thing as a set-it-and-forget-it RRIF.
Using VRIF in a taxable account
VRIF is probably best-suited to income-oriented investors who hold it in a taxable account. Unlike with a RRIF, you won’t have to worry about minimum withdrawals, so you can simply arrange with your brokerage to have those monthly distributions sent to your chequing account and let the investments run on autopilot. No one can argue with that convenience.
So the question then becomes, is VRIF tax-efficient in non-registered accounts? And the answer is—sort of.
To break this down, let’s return to the idea that the cash flow from a monthly income fund has four sources: interest, dividends, capital gains, and return of capital.
Bond interest, of course, is fully taxable. Half of VRIF is made up of bonds, so it will generate a significant amount of interest, which is to be expected (and welcomed) in a monthly income fund. The problem is that today’s extremely low interest rates mean that most bonds are trading at a significant premium. This is an issue I’ve written about before: the full explanation is complicated, but the key idea is that premium bonds are particularly tax-inefficient.
The easiest way to identify an ETF full of premium bonds is to visit its web page and compare the fund’s “average coupon” to its “yield to maturity.” If the coupon is higher, the fund holds mostly premium bonds, and the larger the gap, the more tax-inefficient the fund will be. VRIF’s single largest holding is the Vanguard Canadian Corporate Bond Index ETF (VCB), which has an average coupon of 3.3% and a yield to maturity of 1.7%. That’s not a good combination in a taxable account.
As for dividends, these are only tax-advantaged if they come from Canadian companies: dividends from US and international stocks are fully taxable, like interest. Right now, only 9% of VRIF is Canadian equities, while 41% is foreign equities. So don’t expect to benefit much from the dividend tax credit.
Where VRIF does offer potential for tax-efficient income is through its distribution of capital gains. Remember that Vanguard expects about 60% of the annual yield to come in the form of dividends and interest, with the other 40% being generated from selling holdings and distributing the proceeds as capital gains. Only 50% of a capital gain needs to be reported as income, which makes this type of distribution much more tax-friendly than dividends or interest.
There’s a behavioral benefit here, too. As we’ve said, investors tend to love yield in all its forms, while at the same time showing great reluctance to sell their holdings to generate cash flow, even though the latter strategy can be more tax-efficient. Since VRIF will be harvesting gains behind the scenes, unitholders can enjoy the tax benefits without having to sell any units themselves.
The final type of cash flow from VRIF will be return of capital (ROC), through this expected to be rare. ROC, you’ll remember, is simply the fund paying you back some of your original investment. It’s useful for keeping the distributions consistent during periods when interest, dividends, and capital gains are not sufficient to meet those monthly targets. Since ROC is just your money being returned to you, it’s not taxable as income.
Fund companies like to frame return of capital as “tax-efficient cash flow,” as if it were a great benefit. In fact, it’s not much different from celebrating the fact that your ATM withdrawals are tax-free. And indeed, ROC is not without future tax consequences: it reduces your adjusted cost base on the holding, which means that when you eventually sell your units of the ETF, you’ll realize a larger capital gain (or a smaller capital loss).
Overall, then, VRIF is likely to be about as tax-efficient as your average globally balanced fund, and somewhat more tax-friendly than a monthly income fund that focuses on high-dividend stocks rather than capital gains.
Who shouldn’t use VRIF?
Now that we’ve considered the practical implications of using VRIF to make monthly withdrawals from a RRIF and a non-registered account, let’s consider some situations where monthly income ETFs like this are not appropriate.
We’ll get the first one out of the way quickly, because I hope by now this has become obvious: monthly income funds are absolutely not a substitute for savings accounts. VRIF’s 4% distribution is not the same as a 4% return: like any portfolio of stocks and bonds, this ETF can easily lose money over short periods, so it is not the place to stash your emergency savings, nor the down payment for the house you expect to buy next year. Yes, interest rates on savings accounts are very low, but that’s the price of safety.
By the same token, VRIF is not a replacement for bonds. While the 4% yield is about double what bonds are delivering, substituting VRIF is effectively selling half of your bonds and replacing them with stocks, making your portfolio much riskier.
Others have asked whether a fund such as VRIF would be appropriate for someone making regular contributions to their portfolio, as opposed to drawing it down. Since these investors don’t need monthly cash flow, they suggest setting up a DRIP and reinvesting all of the distributions.
If anything I’ve written over the past couple of weeks has sunk in, it should be clear that such a strategy makes little sense. Since there are already excellent one-ticket balanced ETFs available for accumulators, it’s hard to understand why anyone would use a monthly income fund for this purpose.
For starters, we know that a significant amount of VRIF’s distributions will come from capital gains, which means the fund manager will regularly sell securities to harvest these gains. While this makes sense for investors who need regular cash flow (and tax efficiency in a non-registered account), it’s not a sensible strategy for investors who are planning to reinvest the proceeds. If you held VBAL or VGRO instead, would you periodically sell shares to realize gains and then immediately repurchase them? In an RRSP or TFSA this is merely unnecessary, but in a non-registered account it will generate taxable gains for no reason, when these could be deferred indefinitely.
As we’ve said, return of capital is not likely to be a significant part of VRIF’s distributions, but it makes up a huge chunk of the yield from many other monthly income funds. A surprising number of investors use these funds during the accumulation phase of their lives, reinvesting the distributions rather than spending them. While there is no outright harm in this, it’s hard to make a case for using a fund that is specifically designed to generate cash flow if that cash flow isn’t needed. That’s especially true if those distributions include realized capital gains (which could be deferred) and ROC (which just creates the illusion of income).
If you’re in the accumulation phase of your investing life, stick to traditional ETFs that distribute only interest, dividends and capital gains that can’t be deferred. Vanguard’s own VBAL and VGRO are excellent examples, and there are equally good choices for any target asset mix.
There is no benefit to using a fund that generates regular cash flow if you are just going to reinvest the payouts. However, if you rely on regular withdrawals from your portfolio to fund your spending, then VRIF—with its thoughtful design, low cost and broad diversification—can be a simple, sustainable solution.
Hi Dan, thanks for everything you’ve done for me and the community at large over the years, it’s changed my life for the better!
Do you know if there is a target allocation range for VRIFs holdings? Vanguards prospectus is vague on this. VEE has gone from 1% at inception to 6% end of Dec 21 to 9% as of jan 31 on vanguards site. VRIF makes up about 1/3 of my total investments, and when i use your (again life changing) CCP asset allocation/rebalancing spreadsheet, a 3% EM allocation change month to month makes a huge swing in what needs rebalancing outside the VRIF etf!
Just trying to understand your two comments below. Why is selling a few units to raise $350 inefficient while selling holdings to raise the entire amount better. I’m just not following, sorry.
Of course, in theory you could simply sell a few units of VRIF to free up that extra $350 a month, but this is inefficient, inconvenient, and doesn’t help retirees overcome their reluctance to sell holdings to generate income.
I’d argue there’s a simpler way to manage monthly RRIF withdrawals. At the beginning of the year, as soon as you know how much your required withdrawal will be, you can sell some holdings to raise that entire amount.
@Jay: Thanks for the comment. You’ve hit on the biggest issue with VRIF, in my opinion. Its equity allocation is actively managed and unpredictable. As you’ve found that makes it very difficult to integrate it with the rest of your portfolio. I’m not sure there is any easy fix here, other than to try to ensure your overall stock-bond mix is fairly consistent. (VRIF does seem to stick closely to its overall 50-50 breakdown.)
@Tim: A couple of points here. The first is that if you need to log in to your account every month and make a trade to free up some money, then what is the point of using a monthly income ETF? The whole point of a monthly income ETF is to make that unnecessary. Moreover, most brokerages charge commissions to sell ETFs, so making 12 trades a year is far less efficient than one, especially if you are paying $9.95 to generate (as in this example) only a few hundred dollars.
Thanks for the replay Dan.
As I stated, I was not understanding you statements. Making one trade versus 12 certainly makes sense.
Another question I have is how to incorporate VRIF in a registered account in retirement. My wife and I currently hold an overall allocation of 55% equities and 45% fixed income in our accounts. This is made up of only VCN, XAW and ZAG. We have a DC account, a rrsp, a srsp, two tfsa, a LIRA and a non-registered account. Almost all of ZAG is in rrsp, srsp, LIRA and DC accounts with only equities in non-registered and TFSA. Retirement is 5 years away.
When in decumulation, holding 100% VRIF in our registered accounts is attractive (for ease of withdrawals) but I’m thinking that having only VRIF in those accounts may not give me enough flexibility to balance our overall portfolio as we decumulate. However, having XAW, VCN, ZAG and VRIF in all of our 4 registered accounts and maintaining an overall 55%/45% allocation could get complicated. A thought I had was to hold XAW, VCN and ZDB in our non-registered account, so as to balance our overall 55%/45% allocation, and hold only VRIF in the non-registered accounts. This would mean selling units of VRIF each year to fit with minimum RRIF/LIF/LIRA withdrawals. Why would I need more than VRIF in the registered accounts if I can balance the overall portfolio using the non-registered account?
@Tim: There are a lot of moving parts in your plan, so I can’t offer too much specific advice. Overall, I agree with the goal of keeping the number of holdings to a minimum, because rebalancing across five accounts is a challenge.
One idea might be to use an asset allocation ETF that is 60% equities (such as VBAL, XBAL or ZBAL) in all the registered accounts instead of VRIF. If you need to sell shares of VRIF annually anyway, then it really offers you no meaningful advantage. And the difference between 55% and 60% equities is probably trivial.
In the taxable account, VEQT/XEQT/ZEQT would take the place of VCN and XAW, simplifying even more.
Hello Dan, thanks again for the reply.
Since VRIF only pays out 4% and the RRIF minimum withdrawal is more than that, what is the advantage of holding VRIF versus something like VBAL. Is it only the consistent 4% income stream, and the ease of it all? By my calculations, if you only have VRIF in a RRIF at retirement (65) and withdraw the required RRIF amount each year, by selling some VRIF, you will still have 47% of your initial capital (not indexed) at age 90. That doesn’t sound like such a bad outcome for many people. As an example, should a person have, say 80% VRIF and 20% VBAL in a RRIF and sell VBAL to make up the difference between the 4% and the minimum RRIF withdrawals each year? Your article suggests selling some VRIF each year in a RRIF but is there a better way?
I hold VRIF in a non-registered account and in a TFSA. I use the income from my non-registered account and plan to acquire more shares in my TFSA over time (with the distributions) and bring down my average cost.
I am also planning to transfer my allowable contribution “in kind” for the next five years or so.
Would I be correct in thinking that I would not have to worry about withdrawal or tax issues?
Thanks very much for your work.
@Mark Bell: I’m not clear on which specific “withdrawal or tax issues” you mean. If you make in-kind contributions from a non-registered acconut to a TFSA, there is a deemed disposition, which means the shares are treated as though they were sold. So there would be a taxable gain if the shares have appreciated in value. If the shares have lost value, you would not be able to claim a capital loss because it would be a “superficial loss.”
Is this what you were asking about?
Sorry for being unclear… I am aware of the “ deemed disposition “. I am trying to understand how “income” from a 50/50 RIF will be taxed.
How is the money I make from my non- registered VRIF taxed? Is it 100% taxed at my marginal rate?
I’m thinking the VRIF within my TFSA remains tax free? Am I thinking right?
Thanks so much !
@Mark: Thanks for clarifying. Yes, any income earned in a TFSA is tax-free, as are any withdrawals from the account. If you hold VRIF in a taxable acconut, you will receive a T3 slip at tax time with the details of the income you need to report. It will be a mix of interest, Canadian dividends, foreign dividends and capital gains.
I’m wondering if the ticker “VRIF” is confusing. Despite the similarity in name, the fund has no relationship to a RRIF account, which is subject to different tax rules.